27. Transaction Costs

Transaction Costs

Transaction costs are costs from buying or selling (trading) stocks or other assets. The main type of transaction cost for institutional investors (mutual funds, hedge funds) are the costs of moving the market price from large trades. Let’s say a buy-side fund wishes to sell a large number of shares of a particular stock. If they went to a sell-side market maker (an investment bank), the market maker may initially buy at a competitive price, but may ask for a cheaper price to buy more and more of the stock that the fund wishes to sell. Why is this? Well, the market maker’s job is to always be ready to buy, or always be ready to sell. So the market maker wants to be compensated with a cheaper price for taking on more risk of buying all stocks that the fund wishes to unload. From the buy side fund’s perspective, this cheaper price is a transaction cost.

Transaction costs may be difficult to estimate until trading takes place, so a way to compare how costly a strategy may be is by checking how often the fund needs to make a trade. If a strategy requires trading every day as daily data is updated, this may incur more transaction costs compared to a strategy that requires trading once every three months.