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Bypassing Trading Frictions?

| | Posted in: Individual Investing

Several readers have proposed that one can bypass trading frictions (transaction fees and bid-ask spreads) for market timing strategies via an account with a mutual fund manager that allows free and frequent fund switching, such as ProFunds and Rydex/SGI. Such switching is limited to the end of the day, and these funds do have annual management fees. Does this approach truly bypass trading frictions?


For specifics, consider ProFunds. The “Trading Policies at ProFunds” do “permit exchanges among ProFunds with no upper limit on size or frequency and no transaction fees…to accommodate frequent trading and large movements of assets in and out of the ProFunds.”

The December 1, 2009 summary prospectuses for the Bull ProFund (which seeks to match the return on the S&P 500 Index on a daily basis) and the UltraBull Profund (which seeks to double the return on the S&P 500 Index on a daily basis) offer examples of the fees involved in owning such funds.

For the Bull ProFund (underlining and bolding added):

Shareholders currently pay annual operating expenses of 0.75%  for “Investment Advisory Fees” and 1.04% for “Other Expenses,” less  -0.06% for “Fee Waivers/Reimbursements,” for a total annual expense of 1.73%.

In addition, the Bull ProFund “pays transaction costs, such as commissions, when it buys and sells securities (or ‘turns over’ its portfolio). …These costs, which are not reflected in annual fund operating expenses…, affect the Fund’s performance. During the most recent fiscal year, the Fund’s annual portfolio turnover rate was 839% of the average value of its entire portfolio. However, this portfolio turnover rate is calculated without regard to cash instruments or derivatives. If such instruments were included, the Fund’s portfolio turnover rate would be significantly higher.”

For the UltraBull ProFund (underlining and bolding added):

Shareholders currently pay annual operating expenses of 0.75%  for “Investment Advisory Fees” and 0.90% for “Other Expenses,” for a total annual expense of 1.65%.

In addition, the Bull ProFund “pays transaction costs, such as commissions, when it buys and sells securities (or ‘turns over’ its portfolio). …These costs, which are not reflected in annual fund operating expenses…, affect the Fund’s performance. During the most recent fiscal year, the Fund’s annual portfolio turnover rate was 697% of the average value of its entire portfolio. However, this portfolio turnover rate is calculated without regard to cash instruments or derivatives. If such instruments were included, the Fund’s portfolio turnover rate would be significantly higher.”

In other words, the funds recover the costs of turnover (which include the effects of bid-ask spread and impact of trading) from shareholders. It seems reasonable to view investors/traders using funds (whether mutual, hedge or exchange-traded) as effectively outsourcing trading frictions. Funds may be able to operate so much more efficiently than individuals that there is a net savings (after annual fees) compared to an individual attempting to construct a comparable portfolio.

Could daily frictions absorbed by funds, such as those described above, defeat a trading rule constructed to exploit an anomaly derived for an underlying index by producing a return distribution materially different from that of the index? Testing the rule directly on the funds to be traded, if they have long enough histories, seems desirable to mitigate the risk that the answer is yes.

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