Trading Costs: Pros Share Tips on How to Slap the Invisible Hand

The pair broke trading costs into two key baskets—brokerage commissions, which mutual funds are required to disclose in their statements of additional information, and so-called frictional costs, which are not disclosed but nonetheless can take a bit out of fund returns. If the bid-ask spread—the differential between what buyers are willing to pay for a security and the price at which sellers are willing to part with it—is wide, those frictional trading costs will be higher. Generally speaking, the more liquid the security (i.e., the more buyers and sellers there are), the narrower the bid-ask spread will be.

Deere pointed out that larger buyers of less-liquid securities can find themselves confronting particularly high frictional trading costs. “Say you went into a drugstore needing 25 tubes of toothpaste,” he said. “If you need five more than are on the shelves, the price of the ones in the stockroom will be the same price as the ones on the shelf. On Wall Street that’s not what happens. If you buy five more, they’re going to be a higher price.”

While fund firms may track trading costs internally, they’re not disclosed to the public. However, the pair shared examples of investment types that tend to incur higher trading costs than others. On the short list? High-turnover funds, and those that traffic in less liquid stocks, especially small- and micro-caps. Clark noted that the bid-ask spreads for the large-caps that populate the S&P 500 are apt to be minimal, whereas bid-ask spreads for small-cap stocks could be 200 as high as basis points or more.

Clark advised investors to check out the daily trading volume of the securities in a portfolio to gain a view of the liquidity of its holdings. The pair also agreed that emerging markets stocks can have wider bid-ask spreads from those from developed markets.

Deere pointed out that client activity can jack up turnover, which in turn can heighten trading costs. “If you’re in a fund that has a lot of noisy turnover caused by client flows, unless it’s a very inexpensive fund, I’d be inclined to find another fund.” Complex strategies, such as those that involve leverage, can also lead to higher trading costs, he said. “As you go more esoteric, you’ll have to pay a premium.”

Yet as big a negative as trading costs can be, the two concluded that costs have come down substantially for investors over the past decade, especially commissions. Deere noted, “It used to be that you’d pay 10 basis points (0.10%) in trading costs; now if you pay more than 1 cent it raises eyebrows.” The advent of electronic trading has also squeezed bid-ask spreads, the two panelists concurred. But, Clark noted, “frictional costs have fallen more modestly.”

Christine Benz is Morningstar's Director of Personal Finance.