Transactions Costs, Turnover, and Trading Introduction Transactions costs, turnover, and trading are the details involved in moving your current portfolio to your target portfolio.1 These details are important. Studies show that, on average, active U.S. equity managers underperform the S&P 500 by 1 to 2 percent per year,2 and, as Jack Treynor has argued, that average underperformance can only be due to transactions costs. Given that typical institutional managers seek to add only 2 to 3 percent active return (and charge ~0.5 percent for the effort), this is a significant obstacle. Transactions costs often appear to be unimportant. Who cares about a 1 or 2 or even 5 percent cost if you expect the stock to double? Unfortunately, expectations are often wrong. At the end of the year, your performance is the net result of your winners and losers. But winner or loser, you still pay transactions costs. They can be the investment management version of death by a thousand cuts. A top-quartile manager with an information ratio of 0.5 may lose roughly half her returns because of transactions costs. They are important. 1In fact, they should influence your choice of target portfolio. 2A 1992 study by Lakonishok, Shleifer, and Vishny measured equal-weighted underperformance of 1.3 percent and capitalization-weighted underperformance of 2.6 percent relative to the S&P 500 for 341 U.S. equity managers over the period 1983 through 1989. A 1995 study by Malkiel looked at active equity mutual funds from 1982 to 1991. Interestingly, the naïve analysis showed an average underperformance relative to the S&P 500 of only 43 basis points, but after accounting for survivorship bias (including funds which existed but disappeared prior to 1991), the average underperformance increased to 1.83 percent.
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