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Transaction Costs: The Cause of Crowding?

A researcher argues trading costs do not lead portfolio managers to make similar investments—but in fact help them to differentiate.

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.

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.”

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