How much does buy-side trading cost?
One of the things that’s hard to appreciate about the US stock markets is how huge they are.
The United States has the largest market capitalization (representing $59 trillion in market capitalization). According to our estimates, US households hold about three-quarters of all stocks through pension funds and mutual funds ($24 trillion) as well as direct holdings ($20 trillion), which represents approximately $44 trillion in investment at current market levels (Table 1).
US stocks are also the most liquid (trading at $106 trillion in 2021). But how many trades are investors making and what are the implicit liquidity costs they are asking for?
How many trades do investors make?
As we have seen in the past, markets are an ecosystem of different participants, with different ways of investing. Commodities like futures and exchange-traded funds (ETFs) often trade great on their own, but affect stocks less than you might think.
Using several sources, we have previously estimated the amount of transactions made by the various participants. This showed that market makers and arbitrage strategies, whose purpose in the market is to keep processes efficient and spreads tight, probably trade even more than real investors. However, most of these trades are important to reduce trading costs and mispriced liquidity for real investors.
Chart 1: In 2019, we estimate that institutions and retail represent a much smaller proportion of transactions than the share of assets they represent
How many trades do US investors make?
Today, we focus on genuine US investors (US pensions, mutual funds, and direct holdings).
We begin by market pricing our 2019 trade and asset estimates using the most recent 2021 prices and data.
We adjust institutional transactions (mutual funds and pension funds) for stock price appreciation. We calculate that their transactions, including cash flow, are probably around $90 billion every day, or 21% of all purchases. and sale of shares on the market. Over a year, that adds about $23 trillion in transactions.
Many recent studies suggest that retail trade has increased over the past two years. We’ve re-estimated retail trade to account for this as well as rising stock prices, to likely be closer to $56 billion every day, or 13% of all daily buying and selling.
We note that this is higher than our estimates for tracking retail activity. This is likely due to the additional retail trading using limit orders, which cannot be distinguished on the consolidated band as they are primarily trade-based and occur at full ticks.
However, it is closer to Rosenblatt’s estimates, made using 606 monthly data, that suggest retail represents 18% to 24% of all stocks traded once you consider both sides of every trade. However, we note that because retail trade tends to focus on small cap stocks, they represent much less of the value traded (what we are comparing here).
Table 1: We reestimate new assets and business contributions from US investors using 2021 data
It is important to note that the separation of index funds and ETFs from active funds highlights their different portfolio rotation and shows how little index funds tend to trade. Moreover, as we have shown previously, index funds tend to concentrate their trades on the close of index rebalancing days.
This means that active funds (and hedge funds), which expend resources to analyze stock fundamentals, are also much more important for price discovery.
Chart 2: Asset Allocation and Trading of US Investors
Trading fees include more than commissions
All traders have a mix of explicit and implicit costs to trade, including:
- Commissions: Most institutional traders pay commissions to their brokers. Although for many retail investors, since the end of 2019, transactions are commission-free.
- Spread the costs: All investors must decide whether they are trying to capture the spread or capture the liquidity when trading. However, those trying to capture the spread will not always get a trade at this price. When this happens, they must adjust limits upward as prices rise, paying the spread or more just to complete a trade.* In fact, research even suggests sophisticated broker algorithms. cross-spread 20% more often that they do not capture it. In short: propagation costs are hard to avoid.
- Market Impact: large traders, like mutual funds, also need to “work” their orders. Over time, their buy request drives up the breakeven price of the stock. This “drift,” caused by changes in supply and demand, is known as market impact.
There is also an opportunity cost for those who did not complete a trade and missed the price appreciation that followed.* But they are far less obvious, harder to measure, and about which there is little public data.
Mutual fund trading costs could be around $70 billion a year
We know that mutual funds do the most transactions for investors and have the largest transactions, so it’s worth considering what their transaction costs are.
According to Bloomberg, mutual fund commissions are in addition to about $9 billion every year. Commissions essentially include all fees covering access to broker research, their sophisticated algo software and router hardware, as well as exchange fees charged to brokers for trading, data and colocation.
Data on market impact and propagation costs are harder to come by. However, one of the industry experts on institutional trading costs is Virtu’s institutional trading activity. They have been following the mutual shortcomings of real exchanges around the world for years.
According to their data, the United States has the lowest transaction costs in the world. Even after adding commissions, in a recent SIFMA study, the total costs added to less than 0.35% per transaction. They also estimated the shortfall was almost 92% of that total or 31.5 basis points.
Chart 3: US transaction costs are the lowest in the world
The shortfall includes a combination of variance and impact costs, although it is often measured halfway between bid and bid when the full (parent) order is first created. Spreading spreads and impact costs requires knowledge of the magnitude of spreads for different stocks and the extent to which an algorithm must cross spreads to execute an order – which itself is determined by the speed at which an investor wants to trade.
However, we can see that the wider spread stocks cost more to trade than the tighter spread costs by comparing the cost of the shortfall and the spreads of US large and small cap stocks. This is confirmed by the operation of most industry TCA forecasting models, as well as the results of the US Tick Pilot. Wider spreads increase trading costs.
Importantly, turnover is surprisingly constant in most stocks in the Russell 3000 – thus building a similar “size” position, representing 1% of outstanding shares in a large-cap or small-cap stock. , should take about the same time and signal demand to the market in the same proportion.
Chart 4: Small cap costs and spreads are both higher
So, now that we understand all of this, we can go back to estimating the original question. Over an entire year, how much does it cost investors to trade? Here are some calculations on the back of the envelope:
- Mutuals and pension funds negotiate 90 billion dollars every dayincluding cash flow
- This adds approximately $23 trillion more than a year
- If the average trade costs 31% in deficit, this is in addition to approximately $70 billion every year
Obviously, these are important numbers, and this only applies to US-based (managed) institutional assets.
As we said at the beginning, US stock markets are so huge that it is sometimes difficult to put large totals into perspective. For an investor, this represents friction of barely 0.33% of all institutional assets. So while trading costs impact returns, they affect outperformance and earnings less than it might appear.
Efficient markets matter
The reason this is important is that the scale of the number shows how much of a difference efficient markets make. Each basis point of deficit adds up to approximately $2.2 billion in business impact costs. That’s why we think tight spreads and workable liquidity are also important.
Small improvements in trading could easily generate big savings for US mutual fund investors, which should also improve costs of capital for issuers. That’s why we spend so much time here studying the microeconomics of trading.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.