The Vanguard Group, Inc.
February 23, 2004
Mr. Jonathan G. Katz, Secretary
Re: Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs (File No. S7-29-03)
Dear Mr. Katz:
The Vanguard Group, Inc. appreciates the opportunity to respond to the Securities and Exchange Commission's request for comments on measures to improve disclosure of mutual fund transaction costs. Vanguard offers 118 U.S. mutual funds with assets of approximately $725 billion. We serve approximately 17 million shareholder accounts.
Without question, costs are a very important determinant of net investor returns. Indeed, we have built our reputation on the principle that costs matter. Common sense dictates that, all things being equal, a fund with lower total costs will outperform a fund with higher costs. There are numerous academic studies that confirm the importance of costs in determining performance. Costs are not limited to the operating costs included in the expense ratio of a mutual fund, but also include portfolio transaction costs, which are frequently misunderstood and systematically underestimated by investors. We strongly support increasing investors' awareness of transaction costs and their impact on investment returns.
I. Summary of Recommendations
Based on a thorough analysis of various approaches for providing information about transaction costs, we recommend that the Commission pursue the following actions:
1. Require funds to disclose information about those transaction costs that are accurately quantifiable and comparable across mutual funds. As more fully described below, we do not believe that total transaction costs can be quantified with the degree of accuracy required to make definitive statements about their magnitude. We do believe that portfolio turnover, combined with information about average commission rates (for stock and balanced funds), provides the basis for investors to make some determinations about the level of total transaction costs, and so we support enhanced disclosure about turnover and commissions.
2. Require enhanced narrative disclosure about transaction costs in the prospectus. The narrative, among other things, should explain the impact of transaction costs on fund returns and note that the expense ratio does not include transaction costs. >
These requirements would provide investors with valuable information and insight into the very real costs that funds pay to purchase and sell securities.
A. Proposals to Quantify Transaction Costs
The Concept Release identifies the components of transaction costs and the difficulty of quantifying several of those components. We, too, have observed that calculations of total transaction costs using different methods, such as implementation shortfall and volume weighted average price (VWAP), can produce very different estimates, and can even result in reverse rankings of trading efficiency across a universe of funds.
Index funds, for example, should have low transaction costs. They typically incur only small market impact costs because, with the exception of changes to the composition of the benchmark index, they buy and sell securities only in response to net cash flow, and those buys and sells are spread across the many stocks in the fund. As a result, the number of shares traded on any particular day of any particular stock tends to be quite small. Index funds also incur little, if any, opportunity costs because most index funds execute trades at or near the market's close to ensure close tracking of the benchmark index. So the primary components of transaction costs of an index fund are commissions and the bid-offer spread. In our experience, these are the two smallest components of transaction costs.
Implementation shortfall calculations of Vanguard's index funds confirm that they have very low transaction costs. On the other hand, VWAP comparisons produce very volatile results. In a rising market, trades at the end of the day appear to be very expensive compared to VWAP; in a falling market, such trades appear to be very cheap. Accordingly, the results of measuring transaction costs for an index fund using the VWAP comparison method can be greatly affected by the direction of the market. Since markets tend to rise over time, VWAP would tend to make the trading costs of index funds look high, when they are in fact quite low.
Measuring transaction costs using implementation shortfall methodology, as with VWAP comparisons, can provide a misleading picture. In theory, implementation shortfall is an excellent - and comprehensive - way to measure transaction costs. Unfortunately, the theory is almost impossible to translate into reality. Calculating implementation shortfall requires a huge amount of recordkeeping by an adviser and its personnel. If they fail to keep precise records, the calculations are estimates, at best, if not wholly invalid. Advisers to different funds may collect data differently, or one may not be as rigorous in its recordkeeping, making any comparison of the funds' total transaction costs meaningless.
Furthermore, the main reason for requiring disclosure about past transaction costs is to help investors predict future costs. The fee table required in the prospectus is very useful to investors because the operating expenses incurred by a fund tend to vary little from one year to the next. (Indeed, if operating expenses for the coming year are expected to differ materially from the previous year, the fund must restate the expense information in the table.) Estimates of transaction costs using an implementation shortfall approach, on the other hand, can vary dramatically from period to period, depending on whether the market environment is favorable or adverse for the types of stocks being traded. Using an implementation shortfall methodology, one of Vanguard's active equity funds has incurred transaction costs on the amount traded varying from 181 basis points during one time period to -139 basis points over another (a negative number indicates that the adviser's trading methods added value to the fund).
The Concept Release also mentions "trade effect" measurements as a means to quantify transaction costs. Trade effect combines the impact of portfolio management decisions with transaction costs, and does not distinguish which component had a greater impact. Since both components are volatile - portfolio management decisions add value during some periods and destroy it during others, and transaction costs can vary substantially, as described above - information about past trade effects are not predictive of subsequent trade effects. Therefore, we urge the Commission not to require funds to disclose trade effect measurements.
The foregoing discussion highlights the difficulties of trying to calculate transaction costs for domestic equity funds. Estimating transaction costs becomes significantly more difficult for international equities and virtually impossible for fixed income securities. Regardless of the method of calculating transaction costs, an accurate computation requires tick-by-tick data. In many foreign countries and in the United States bond market, that information simply is not available.
For these reasons, we believe that a single point estimate of transaction costs would be misleading. It conveys a greater ability to calculate transaction costs than actually exists. Investors would naturally assume that any number stated in the prospectus or annual report is reliable, and they would likely place undue significance on it. Although we support the concept of providing investors with as much cost information as possible, any information provided must be accurate (not an estimate), meaningful, objective, and comparable across funds. Because no measure currently exists that fits those criteria, we do not at this time support disclosure of "all-in" transaction costs.
B. Recommendations for Improving Disclosure of Transaction Costs
Although there is no single measure that accurately quantifies transaction costs, we strongly believe that investors will make better decisions if they have a better understanding of how transaction costs affect fund performance and a reasonable idea of the scope of those costs. To provide investors with this knowledge, we believe the Commission should require funds to include in the prospectus the following information, presented together in one place:
We believe that increasing the visibility of a fund's turnover rate is crucial. It is easily quantifiable, generally understood by investors, and most important it is a critical factor in determining transaction costs.3 Turnover rate is a good indicator of total transaction costs not only for stock funds, but also for balanced and bond funds.
Currently, information about a fund's turnover rate is required to be disclosed in the fund's Financial Highlights.4 Most Vanguard funds, in the body of the prospectus, tell investors what the turnover rate of the fund's peer group is and direct investors to the Financial Highlights to see the fund's turnover rates for the past five years. The prospectus also contains additional information in a callout box entitled "Plain Talk About Turnover Rate," which reads as follows (emphasis added):
Before investing in a mutual fund, you should review its turnover rate. This gives an indication of how transaction costs, which are not included in the fund's expense ratio, could affect the fund's future returns. In general, the greater the volume of buying and selling by the fund, the greater the impact that brokerage commissions and other transaction costs will have on its return. Also, funds with high turnover rates may be more likely to generate capital gains that must be distributed to shareholders as taxable income.
Information of this sort, enhanced as noted above, would go a long way to helping investors make more informed investment decisions.
Portfolio turnover rate alone, however, does not give a complete picture of trading costs. Certain stocks, such as small-cap and foreign stocks, tend to be more expensive to trade. Thus, a high turnover large-cap stock fund may have lower transaction costs than a lower turnover small-cap or foreign stock fund. To give investors a more complete picture about transaction costs, funds should disclose the approximate commission rate for each trade, expressed in cents per share. This disclosure would have the added benefit of incenting funds to limit or eliminate the soft dollar practice of "paying up" for research.
C. Review of Transaction Costs by Fund Directors
The Concept Release requests comment on whether existing requirements for board review of transaction costs are adequate. It is common practice for advisers to provide fund boards with information about trade execution, broker selection criteria, soft dollars, and directed brokerage. Moreover, new Rule 38a-1, effective October 5, 2004, will require a fund's board to approve the fund's compliance policies and procedures. According to the adopting release5, those policies and procedures should address, among other things, the fund's trading practices, including procedures by which the adviser satisfies its best execution obligation and uses client brokerage to obtain research and other services. We think the Commission should evaluate how Rule 38a-1 is working before mandating additional disclosure in this area.
As a practical matter, we believe that boards should, and currently do, receive both qualitative information and quantitative data about a fund's trading practices. What is most important is that the information and data provided is sufficient to permit the board to fulfill its oversight obligations. In our view, those obligations include determining that the fund's transaction costs are appropriate in light of the fund's asset class, investment objectives, and strategies.
While we fully support meaningful disclosure of mutual fund costs, we recognize the importance of providing information that is consistent across all mutual funds. Clearly, for investors to make decisions about the appropriateness of one fund versus another for their investment needs, they must be able to make a meaningful comparison of the two funds.
Certain information is easily quantifiable, and does provide a measure for accurate and meaningful comparison. This includes the expense ratio and the commission component of transaction costs. Similarly, the turnover rate of a fund is easily quantifiable and has a significant impact on transaction costs. On the other hand, implicit transaction costs such as spreads, market impact costs, and opportunity costs, are extremely difficult to quantify.
We are concerned that providing investors with a supposedly definitive calculation of transaction costs that includes unquantifiable costs will actually be misleading. Investors naturally would assume that the numbers are accurate and comparable, potentially leading to bad investment decisions. Instead, we favor providing investors with information about quantifiable measures, combined with an explanation of how they can use that information to draw inferences about a fund's total transaction costs.
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The Vanguard Group appreciates the opportunity to comment on transaction cost disclosure for mutual funds. If you have any questions, or would like additional information, please feel free to contact me.
/s/ George U. Sauter
George U. Sauter