32 – L1 31 Transaction Costs V2

An important consideration for any investor or a portfolio manager is the cost of buying and selling stocks. These are called transaction costs. Transaction costs can be commissions paid to brokers or bargain-making investment banks. Transaction costs can also be the costs of moving the market price by trading a large block of shares. Large institutional investors are primarily concerned with moving the market price by making large trades. For example, if a fund wants to buy a stock that it considers underpriced, a large purchase of many shares will push up the market price of that stock making the original purchase decision less attractive. Usually, traders will break up the order into smaller pieces and make the purchases with different sellers on different exchanges in order to prevent these sellers from raising their prices. Portfolio managers need to consider how different strategies affect their overall transaction costs. For instance, if a strategy requires buying or selling based on daily price movements, this will incur more transaction costs compared to another strategy that triggers trading based on quarterly financial reports. When a portfolio manager decides to adjust their investment allocation, this adjustment is called portfolio rebalancing. When rebalancing a portfolio, a portfolio manager may decided that due to transaction costs it makes more sense to skip trades for which the transaction costs outweigh the benefits of rebalancing. Moreover, for large institutional investors that manage multiple funds, they can trade internally between funds that are within the institution, thereby reducing the cost of rebalancing.