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2.  Brokerage Costs Most explicit, but by far the smallest component  Bid-Ask Spread  Price Impact The change in price an investor can create through price pressure  Opportunity Cost – cost of waiting to trade Price moving against you while you wait 2

3.  Must provide dealer with a reasonable return and cover dealer’s costs  Costs that the dealer faces Risk of holding inventory Cost of processing orders Cost of trading with more informed investors 3

4. Mkt. Cap Smalle st 2345678Largest Ave. Price $4.58$10.3 0 $15.1 6 $18.27$21.8 5 $28.3 1 $35.4 3 $44.34$52.40 Ave. Sprea d $0.30$0.42$0.46$0.34$0.32 $0.27$0.29$0.27 Pct. Sprea d 6.55%4.07 % 3.03 % 1.86%1.46 % 1.13 % 0.76 % 0.65%0.52% 4

5.  Spreads on Treasuries are the lowest – usually less than 0.1% of the price  Higher Rated Corporate Bonds generally have narrower spreads than those that are lower rated  Non-U.S. equities generally have much higher spreads than those traded on NYSE and Nasdaq 5

6.  The recent increase in electronic trading has led to much lower quantity quotes in the inside spread – often only 100 shares  Large trades create an imbalance between buy and sell orders which create a price change  Large trades attract attention and are viewed as informational by other investors – thus changing prices 6

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9.  Assets which have a high bid-ask spread tend to be assets where trading can have a significant price impact as well.  Larger portfolios tend to trade in larger blocks – this means a strategy which yields excess returns for a small portfolio might not for a large one. 9

10.  If there is no cost, every trade should be broken up into small quantities so as to not affect the price or spread  While waiting to trade though, the asset the investor wants to buy may go up in price.  The cost of waiting and the cost of price impact tend to conflict with each other. 10

11.  Trades based on private information (not necessarily illegal) generally have a greater cost of waiting as others may discover the information  Trades based on valuation generally have a lower cost of waiting  Trades based on a contrarian strategy tend to have a lower waiting cost than those based on a momentum strategy 11

12.  Return on active money management = Risk adjusted expected return + Trading returns – Trading costs  The average active money manager makes about 1% less than the market. Trading returns are a zero-sum game, so average trading return must equal zero This implies that average trading costs are about 1% if collectively, they are the market 12

13.  Develop a clear investment philosophy and a consistent investment strategy  Estimate the cost of waiting given the investment strategy  Consider alternatives available to minimize transactions costs, given the cost of waiting  Keep the portfolio size manageable  Consider costs when looking at returns 13