Study: Costs Hurt Big Traders More than Small

April 27, 2007 (PLANSPONSOR.COM) - Money managers who make mega-block trades based on the benefits of the economies of scale may be fooling themselves, a new research paper suggested.

Roger M. Edelen of  Echo Investment Advisors, LLC;  Richard Evans of Boston College and Gregory B. Kadlec of Virginia Tech asserted in a study – Scale Effects in Mutual Fund Performance: The Role of Trading Costs – that trading costs hurt funds with larger trade sizes more than their smaller counterparts.

The researchers also contended that flow-driven trades – those driven by inflows of assets – are “significantly more costly than discretionary trades in a much larger sample and longer sample period than previously documented.”

Trades driven by the receipt of soft-dollar payments are “also associated with substantially higher levels of trading activity and a negative impact on fund performance,” the researchers argued.

The researchers examined 1,706 U.S. equity funds during the period 1995-2005 and found that trading costs have an increasingly detrimental impact on performance as the fund’s relative trade size increases.

The relation between trading costs and fund returns is positive for funds with a small relative trade size and negative for funds with a large relative trade size, the study said. Specifically, $1 in trading costs increases fund assets by roughly $0.40 for small relative trade size funds and decreases fund assets by roughly $0.80 for large relative trade size funds.

The study contended that for large relative trade size funds, $1 in trading cost reduces fund value by roughly $0.80. “That is, managers appear to trade well past the point where their value added exceeds the cost of transacting,” the researchers commented.

The full study is available for download  here .