By Mike Plunkett
Mutual fund fees have come under unprecedented scrutiny by investors in the wake of the industry's scandals during the last year. As we are all well aware, the widespread trading abuses exposed by New York Attorney General Eliot Spitzer has led to settlements with fund companies that include agreements by the firms to reduce shareholder fees.
But even with these reductions, did investors really notice an impact to their bottom line? Well, you tell me. According to the midyear 2004 Standard & Poor's Indices Versus Active Funds Scorecard, for the first six months of 2004, only 37% of actively managed large-cap funds beat the S&P 500, and only 10% of small-cap funds beat the S&P 600 index of small stocks.
The next obvious question for most of us: is there anything the fund managers can do to make a difference?
Anyone who has been reading market reports lately should be well aware that stocks could show volatile performance in the upcoming years. If the institutions that manage these funds can't rely on the market for strong returns, I'd like to recommend they take a closer look at one area I know they can control: trading costs.
Long dismissed by some institutional investors as negligible, the unnecessary costs of stock transactions have revealed themselves as, in fact, unacceptable to the investor. Stock returns are lower now than they have been for many years; therefore the proportionate impact of fees and commissions is greater. As a result, regulators have become more critical and the media spotlight has become more intense. Some institutional investors are even now beginning to feel pressured by their constituents to focus more on the reasons behind the cost of trading.
I see two paths this issue could take, and in either case, the cost of trading will be forced downward, so it is in the best interest of investment managers to act soon.
In the first case, investment managers can choose to wait, and maintain the current cost structure and trading strategies. Investors will demand lower costs, and regulation will increase requirements for transparency and disclosure. But this is not a favored outcome, and any manager who hasn't fine-tuned trading costs by then could suffer an abrupt correction.
In the second case, the manager could get ahead of the issue by moving to execute trades more efficiently, thereby lowering the impact of trading costs on investors' portfolios. Years ago, when some investments were generating returns of 20% or more, this didn't appear to be worth the effort. But now, trading costs that surpass the price of a commission can be a heavy burden to bear.
As many in the pension plan community have unpleasantly realized, most commission dollars are not allocated with the explicit goal of best execution. In fact, according to a Greenwich Associates 2003 U.S. Equity Investors report, only $1 out of every $5 in trading commissions actually goes toward execution, as their investment managers allocate funds from their clients' portfolios for research, management access and other services where the true cost is not disclosed.
The questions for the manager come down to: Can I reduce my average trading commission? Will it matter to the bottom line? The answer to both questions is a resounding yes.
Based on the Greenwich report, investment managers have the ability to allocate about one-third of their trading commissions to execution-only providers that do not offer other services, I believe it could be more if the industry were to price those services discretely, as opposed to bundling them into one commission rate.
By increasing the volume sent to pure execution brokers without any investment banking conflicts, managers could save millions of dollars every year. In some cases, the opportunity cost due to delayed execution can be up to double the trading commission, and in the case of some mutual funds, more than the expense ratio. The Zero Alpha Group found this in a January 2004 study of mutual fund brokerage commissions, yet some people believe that the only way to avoid those opportunity costs is to get broker capital commitment.
I beg to differ. When institutions can trade with one another directly, in an environment without conflicts, it will almost always be a higher quality and lower-cost transaction than any execution you get from a traditional broker. It's no surprise that, according to one global execution cost ranking survey, agency firms are among the top performers; right next to the principal trading desks.
I believe that all institutional investors, including those who manage the portfolios of pension plans, should take more control of trading costs. These actions will save them burdensome expenses that trading places on them and save their clients money in a very tangible way.
Mike Plunkett is president, North America, of Instinet LLC, New York.