The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

TRADING COSTS

A critical element in investment management is controlling the trading costs necessary to implement a strategy. While important, the measurement of trading costs is very difficult.

We begin by defining trading costs. Trading costs can be decomposed into two major components: explicit costs and implicit costs. Explicit costs are the direct costs of trading, such as broker commissions, fees, and taxes. Implicit costs represent such indirect costs as the price impact of the trade and the opportunity costs of failing to execute in a timely manner or at all. Whereas explicit costs are associated with identifiable charges, no such reporting of implicit costs occurs.

Explicit Costs

The main explicit cost is the commission paid to the broker for execution. Commission costs are fully negotiable and vary systematically by broker type and market mechanism. The commission may depend on both the price per share and the number of shares in the transaction. In addition to commissions, there may be other explicit costs. These explicit costs include custodial fees (the fees charged by an institution holding securities in safekeeping for an investor) and transfer fees (the fees associated with transferring an asset from one owner to another).

Implicit Costs

Implicit trading costs include impact costs, timing costs, and opportunity costs.

Impact Costs

The impact cost of a transaction is the change in market price due to supply/ demand imbalances as a result of the trade. ...