In an investment environment where 100 basis points can mean the difference between outperforming and underperforming a benchmark, careful management of costs can yield tremendous dividends. To manage costs effectively, however, investors need a monitoring system capable of capturing and analyzing all data pertinent to the transaction process. Such comprehensive data are critical to a better understanding of the sources of trading costs and their impact on performance.
Transaction costs include commissions, execution costs and opportunity costs. Commissions are fixed and measurable over a period, but execution and opportunity costs are neither fixed nor directly measurable. While there exist various accepted methods for estimating these costs, no one approach is the best in all circumstances. It is thus important to monitor price behavior over the entire transaction process, from the point at which a decision to implement an investment strategy is made through the time a decision is made to change it.
Minimizing trading costs involves identifying the optimal tradeoff between execution costs and opportunity costs. Each investment strategy or style has its own opportunity cost function. Some strategies facilitate patient trading, while others require immediate and aggressive trading.