Transaction Costs: The Cause of Crowding?

Transactions costs are not the sole cause of crowding in investments, a researcher has argued.

While some portfolio managers point to transaction costs as a cause of crowding, the effect “may have had less to do with transaction costs and more to do with other factors,” argued Ludwig Chincarini, associate professor at the University of San Francisco.

“Crowding and transaction costs may not be related in the way that many portfolio managers believed them to be,” he wrote.

According to those pointing the finger at transaction fees, investors seeking to avoid high costs will end up making similar trades at the same time as their peers, flocking towards the cheapest deals.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

For example, if portfolio managers are choosing between two stocks and one stock has a significantly higher transaction cost than the other, those investors will tilt toward the stock that is cheaper to trade, Chincarini said—even if they may have preferred the more expensive stock before transaction fees were taken into account.

However, in a simulation of US equity portfolios trading from 2006 to 2013, Chincarini found that considerations of transaction costs actually decreased crowding.

As the average portfolio size increased from $500 million with no transaction costs to $5 billion with transaction costs, the average crowding declined.

As portfolios grew from $5 billion to $20 billion, transaction costs became higher and crowding did worsen. However, there was still less crowding among $20 billion portfolios that considered trading costs than $500 million portfolios that did not.

“The average crowding for [long-only] portfolios declines as portfolios get large, even though transaction costs are increasing,” Chincarini wrote.

Portfolio managers could even limit crowding by estimating trading costs for an asset base larger than the size of their own portfolios, Chincarinie argued. But, he added, avoiding crowding entirely may not be possible.

“As portfolios and groups of portfolios grow in size beyond $20 billion or beyond the capacity of their stock universe, crowding will be unavoidable,” Chincarini concluded. “However, it is still better to consider transactions costs ex-ante, rather than realize them in spades ex-post.”

Read the full paper, “Transaction Cost and Crowding.”

Buying highly concentrated equity portfolios could raise costs and volatility while reducing the number of outperforming managers, according to research.

“If the typical active manager owns 100 stocks now and converts to holding only 20 or so, the volatility of his portfolio will almost certainly increase.”While “high-conviction” strategies have seen renewed interest in recent years, asset owners should be wary of relying too much on concentrated portfolios, wrote Tim Edwards and Craig Lazzara, directors in Standard & Poor’s index investment strategy department.

“Concentration only makes sense if managers have a particular type of skill, and this skill must be intrinsically rare,” the pair wrote.

However, if high-conviction strategies were to become more widespread, Edwards and Lazzara argued that volatility would increase. Between 1991 and 2016, the pair found that the S&P 500’s average volatility of returns was 15%, while the same figure for individual stocks was 28%.

For more stories like this, sign up for the CIO Alert newsletter. 

“If the typical active manager owns 100 stocks now and converts to holding only 20 or so, the volatility of his portfolio will almost certainly increase,” Edwards and Lazzara said.

This presented asset owners with a dilemma, they added: Either they keep the same number of managers in their equity portfolio, but reduce the actively managed proportion to keep the overall risk at the same level, or they hire more high-conviction managers to replace the diversification benefit.

“The increased concentration of active funds might prove advantageous only to consultants supporting the expanded effort to secure sufficiently diversified active exposures,” the authors wrote.

Transaction costs could also rise with fewer stocks in a portfolio, the authors said. The higher a manager’s stake in a particular stock, the higher the transaction cost is likely to be as a percentage of assets if he wants to trade out.

Edwards and Lazzara also claimed that a skilled active manager “will benefit from having more, rather than fewer, opportunities to display his skill.” Concentrated portfolios therefore blur the boundaries between luck and skill. In addition, managers were more likely to outperform by focusing on cutting out underperformers, they argued.

“The logic of skewed returns”—the idea that a stock can only fall by 100% but can increase by more—“is that it is more sensible to focus on excluding the least desirable stocks than on picking the most desirable—the opposite of what a concentrated portfolio will do,” they said.

The resurgence of the conviction argument was in part down to the emergence of ‘active share’ as a measure of how different a particular fund was from its benchmark, Edwards and Lazzara said. In addition, there has been a “general trend of lower dispersion among stocks” since the financial crisis, pushing managers to put bigger bets on fewer stocks in pursuit of alpha.

Read the full paper, “Fooled by Conviction.”