TRANSACTION COSTS EXPLAINED, Study notes of Technology

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TRANSACTION

COSTS

EXPLAINED

Getting to grips with charging

disclosure under MiFID II and PRIIPs

FOR PROFESSIONAL CLIENTS/QUALIFIED INVESTORS/PRESS USE ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

MYTH 1

Transaction costs are a new cost

The transaction costs disclosed under MiFID II are NOT a new additional cost. They have always been involved in managing a fund and are already fully reflected in net returns. However, this is the first time they have had to be fully disclosed and expressed in percentage and monetary terms.

MYTH 2

Low transaction costs indicate a better investor outcome

Assessing the outcome from investing in a fund requires looking at its performance net of charges. A fund that trades infrequently may have low transaction costs but its strategy may be focused on achieving only modest returns. However, another fund with a more active trading strategy may incur higher transaction costs in order to generate higher long-term returns. Transaction costs (and other charges) must always be considered in the context of a fund’s strategy and the return being achieved.

MYTH 3

Disclosing transaction costs makes competitor comparisons easier

Disclosing transaction costs may encourage fund managers to see how they can reduce the cost of trading, which is to be welcomed. But the very different basis on which costs can currently be calculated can be misleading and confusing for investors – and may actually serve to make fund comparisons harder.

TRANSACTION COSTS EXPLAINED

4 | J.P. MORGAN ASSET MANAGEMENT

What costs does a fund need to disclose?

There are four types of cost that must now be disclosed separately on an investment

fund, both before a fund is sold to an investor and on an ongoing annual basis:

One-off charges Paid when entering or exiting an investment

Initial charges

Front-loaded management fees

Distribution fees

Exit fees on redemption

Ongoing charges Taken annually for managing the fund

Annual management charge (AMC)

Operating and administration

(O&A) costs – e.g. custody and

reporting costs

Stock lending costs

In a fund of funds, the costs of the

underlying funds

Swing Pricing A mechanism used to protect long-term investors in a fund from having the value of their investment eroded by the costs involved in managing short-term fund inflows and outflows – especially during times of extreme market volatility. If a fund experiences unusually high inflows or outflows, the buying or selling price will be systematically adjusted up or down to absorb the impact of higher-than-usual transaction costs. Please see relevant Prospectus for more information on Swing Pricing also referred to as Dilution Adjustment.

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Transaction costs Incurred when trading underlying investments

Explicit costs of trading underlying

investments in a fund

Implicit costs of trading underlying

investments in a fund

(see below)

Transaction costs must take into account two types of cost

Explicit transaction costs

• Broker commission - to buy and sell securities
• Research commission - where the asset manager passes these on to the investor*
• Taxes and levies - such as stamp duty, regulatory and exchange levies
• Securities lending - the cost of borrowing or the admin fee from lending – e.g. for short selling activities

Implicit transaction costs

• Arrival cost - the difference between the price at which an asset is valued immediately before an order (the arrival price) and the price at which it is actually traded (the execution price)

…minus any value obtained from any swing pricing that may occur

*J.P. Morgan Asset Management does not pass these costs on to the investor for all accounts considered in scope of the MiFID II Directive.

Incidental costs Ad-hoc charges

Performance fees

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How is the ‘arrival cost’ calculated?

There are a number of ways of calculating transaction costs. The method used by

J.P. Morgan Asset Management and others to determine implicit transaction costs is

the full PRIIPs method, also known as the arrival price methodology.

What can create the differential between the arrival price and execution price?

A difference between the price at which an order to trade is given and the price at which it is executed can result for a number of reasons:

• Opportunity cost - Sometimes it is not possible to execute a large trade in one go. Executing a trade in stages can create gains or losses depending on how the market price of the security moves.
• Trade impact - Instructing a large trade can have the effect of moving the security’s price up (if buying) or down (if selling). Managing this impact is a key skill for asset managers and their trading desks.
• Delay impact - If a transaction is delayed, for whatever reason – even by a minute or so – market movements in the meantime can contribute to the arrival cost. Powerful trading systems that minimise latency (the delay between a trading request and response) are vital.

1 The arrival price is the mid-price of the security at the exact time the trade is

sent to the broker.

2 The execution price is the price achieved for the whole trade (or the average

price achieved where the trade has been broken down into multiple parts).

3 The arrival cost is the difference between the average execution price and

the arrival price, expressed as a percentage.

In the buy example shown above, the execution price is 101p and the arrival price is 100p, so the arrival cost is 1%.

THE ARRIVAL PRICE METHODOLOGY For illustration purposes only.

Share Price

8am 9am 10am 11am 12pm 1pm 2pm 3pm 4pm 4.30pm

Average price achieved @

“Arrival cost” is 101 – 100 = 1% 100 Manager initiates (^1) buy order @

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Do low transaction costs indicate the

best investor outcome?

It can be easy to assume that the most attractive funds are those with the lowest

transaction costs. But an example of three different managers reacting to news on the

same stock shows that’s not necessarily the case.

Case study: Putting transaction costs in context

Three managers react to some negative news in a stock price:

• Manager 1 sells on the day of the bad news, achieving an execution price of 100, but accumulating an

arrival cost of 4.7%.

• Three days after the newsflow, Manager 2 decides to follow suit and sells. They start their order with the

price at 99, and ends up with an execution price of 98.5.

• Lastly, Manager 3 takes the longest time to decide, enters the sell order on Day 8 once the price has fallen

to 98, and achieves an execution price of 98.3.

Despite all three managers coming to the same conclusion to sell, and each taking one day to execute their

order, the manager who achieved the highest selling price, Manager 1, is considered to have the highest

transaction costs. Indeed, under the above scenario, Manager 3 would show negative transaction costs, but

would have achieved the worst outcome for clients.

Share Price

106 105 104 103 102 101 100 99 98 97 Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10 Day 11 Day 12

Manager 1 initiates sell order @

Manager 2 initiates sell order @

Manager 3 initiates sell order @ Manager 3 average price achieved @98.

Manager 1 average price achieved @

Manager 2 average price achieved @98.

Manager 1 “Arrival cost” is 105 – 100 = 4.7% 105

Manager 2 “Arrival cost” is 99 – 98.5 = 0.5% 99

Manager 3 “Arrival cost” is 98 – 98.3 = -0.3% 98

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What are the implications of the new rules?

Costs have a major impact on investor returns. The regulatory intent of MiFID II and

PRIIPs to enable investors to see and understand fully all the costs involved in investing

in a fund is to be welcomed and supported.

Minimising trading costs by trading as efficiently and cheaply as possible has always been a priority for asset

managers in order to show better net returns. Shining a light on transaction costs may encourage asset

managers to work even harder to bring these costs down.

But there are three important factors to bear in mind:

1 Hard to compare costs on a like-for-like basis: The flexibility given to fund managers to use different

calculation methods and swing pricing mechanisms to measure transaction costs makes it very difficult

to make a meaningful comparison of transaction charges, even on funds with a similar mandate.

2 Transaction costs need to be put into context: Different funds can have very different cost profiles

depending on their investment strategy and how frequently they trade. Transaction costs therefore need

to be assessed against the aims, strategy and risk profile of the fund – never in isolation.

3 Regulatory disclosure is not consistent: Performance figures in a Key Investor Information Document

(KIID), which is governed by UCITS legislation, may be based on a different time period and include

different costs from those shown in MiFID and PRIIPs disclosures (for example, KIIDs do not have to

show any type of transaction costs). Investors may therefore be presented with different costs for the

same fund, depending on what documentation they are looking at.

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Managing transaction costs at

J.P. Morgan Asset Management

• Investing in best execution: J.P. Morgan Asset Management is committed to achieving best execution for

all transactions we conduct. We invest extensively both in proprietary trading technology and teams of

trading specialists to drive down execution costs and achieve the best trading outcome for the benefit of

our clients.

Our Global Equities team comprises 34 traders around the world, augmented by a further six experts within our

dedicated Systematic Trading and Analytics team (as at 30 April 2019) that focuses solely on improving trading

efficiency. Using data-driven machine-learning processes, we identify the optimal trading style in various trading

situations. Through this agile, quantifiable approach, we strive to keep our transaction costs low.

• Clear and accurate disclosure: We calculate transaction costs using the full PRIIPs methodology, using

three-year historic data which is refreshed monthly.

• Not passing on research costs: We were also one of the first asset managers to pay explicitly for third-party

research, clearly separating the provision of research from the cost of transacting. Today, we have a policy

not to pass on the costs of third-party research to investors for investments covered by MiFID II.

We continue to invest in research and technology to achieve optimal trading outcomes without ever

compromising security or reliability.

Markets Media Markets Choice Awards Winner for three consecutive years: Best Buy-Side Trading Desk 2016, 2017 & 2018

Past performance is not an indication of current and future performance.