Toronto - Active investing has been criticized for leading to lower performance, partly because all that trading racks up costs.
But new research examining rare information about individual trading transactions among Canadian mutual funds shows that high trading costs can correspond to high fund performance, at least when it comes to securities the fund buys.
“Higher trading costs can mean something positive,” said finance professor Susan Christoffersen, who is the Dean and the William A. Downe BMO Chair in Finance at the University of Toronto’s Rotman School of Management. “The fund manager has good information about the trade’s prospects and as a result, they’re paying higher trading costs to execute on that.”
Prof. Christoffersen and three colleagues were able to probe these ideas thanks to access to Canadian fund transaction data from 2001 to 2003 that provided information right down to individual transactions. This allowed the researchers to analyze the costs of each trade and compare those to their returns and the fund’s performance. No other country provides that detailed data. Even Canada stopped requiring it from mutual fund companies not long after the period the researchers studied.
While the researchers discovered that fund managers did pay higher costs when they wanted to act on their trading ideas and information, by buying securities – known as “demanding liquidity”– the data showed the costs ultimately paid off through superior returns. In fact, more expensive trades performed better than cheaper ones.
Cheaper trades weren’t necessarily a loss either. Instead of trying to make money through investment performance, fund managers tried to earn profits through the difference between the sellers’ price and what the managers offered to pay, known as the bid-ask spread. The one area where trading costs were a net drag on performance was when funds were forced to sell securities.
But what first caught Prof. Christoffersen’s eye was that funds sometimes made extremely big trades, yet with few costs. The general wisdom is that large security trades should equal high costs because there is some urgency on the trader’s part.
“What we saw was this weird relationship where the costs would go up for a little bit and then they would come down” after the trade went beyond a certain size, said Prof. Christoffersen.
Instead of demanding liquidity, the funds designed the trade so that they were supplying it, providing opportunities to other investors. “Some of these really large trades were out there providing liquidity to the market,” said Prof. Christoffersen. “They were saying, ‘Yeah, we’re willing to sell, but we’re going to sell at a slightly better price, or we’re going to buy to try to make money on the spread.”
The research shows that investors should look at the relation between a fund’s performance and its buy costs rather than its overall trading costs before deciding how good or bad it is.
“There seems to be some value to active management,” said Prof. Christoffersen. “Mutual fund managers are trying to manage trading costs and they’re pretty good at it.”
The paper was co-written by Donald Keim and David Musto of the University of Pennsylvania, Aleksandra Rzeźnik of York University’s Schulich School of Business. It appeared in the Review of Finance, one of the fifty academic and practitioner journals used to calculate the research ranking in the annual Financial Times ranking of business schools.
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