One of the main arguments for investing in passive index funds is the relative assurance of reaping a fair share of market returns. But as market benchmarks bear no costs, an index fund manager needs to reduce frictional costs in order to better attain the market return. Costs include not only the fund expense ratio, but also the fund’s transaction expenses for buying and selling securities.
While mutual fund managers rarely provide specific details concerning proprietary trading techniques, there are certain trading mechanisms that clearly reduce transaction costs. For example, mutual fund managers can reduce transaction expenses through the use of cross trading securities and by making in-kind transactions when buying and selling securities.
A cross trade takes place when an investment manager “swaps” a security between separate funds that he or she manages. These types of transactions are regulated by section 17 CFR 270.17a-7 of the Investment Company Act of 1940 and, for plans governed by ERISA, the Statutory Exemption for Cross-Trading of Securities. The manager must prove a fair market price for the transaction and record the trade as a cross for proper regulatory classification.
An example will let us see how a cross trade eliminates transaction costs. Suppose our manager operates both a small cap growth index fund and a mid cap growth index fund. When the tracker indexes reconstitute, a small growth company is reclassified as a mid cap growth company. If the manager uses market transactions to sell the stock from the small cap index fund, and then buy the stock for the mid cap index fund, the funds will pay brokerage commissions and spread costs on both the sale and purchase. Alternately, with a cross sale transaction, the manager will trade internally between the funds. There will be no commission expense for this trade and there is no need for a bid ask spread.
In-kind transactions are permitted for both mutual funds and exchange-traded funds. In-kind purchases and sales of securities are specifically used by exchange-traded funds. With securities being transferred in-kind, there are no brokerage commissions or bid ask spreads incurred since there are no sales or purchases of the transferred shares.
The Vanguard annual reports for fiscal year 2016 provide, for the first time, information which allows us to measure the amount of cross-trading in US stock market index funds, as well as US bond market index funds and US tax-exempt bond funds. Vanguard provides this information in a footnote in a fund’s annual report, with the following comment:
The fund purchased securities and sold securities to other Vanguard funds or accounts managed by Vanguard or its affiliates, in accordance with procedures adopted by the board of trustees in compliance with Rule17a-7 of the Investment Company Act of 1940.
Vanguard US stock index funds
Estimates of stock fund transaction expenses, which include brokerage commission expense, bid and ask spread costs, and market impact costs, have been studied:
- Haslem (2006) estimates trading costs of actively managed funds impacting returns by -0.60%.
- Edelen, Evans, and Kadlec (2013) estimate transaction costs of 1.44%.
- John Bogle (2014) uses a more conservative estimate of 0.50%.
The first table below provides data for cross trades made during the 2016 fiscal year in Vanguard US stock index funds. The only funds that did not cross trade in 2016 were the Total Market, Large Cap, and Small Cap index funds.
The second table provides data for in-kind transactions. Combining figures from both tables indicates the percentage of transactions that cut transaction costs. Using the Vanguard Value Index Fund as an example, approximately 69% of stock purchases and approximately 64% of stock sales were executed as cross trades or in-kind transactions.
Cross trading (2016)
| Fund | Purchases | Cross Purchases | Pct. Purchases | Sales | Cross Sales | Pct. Sales |
| Vanguard Total Market | 76,882,731,000 | 0 | 0.00% | 24,431,366,000 | 0 | 0.00% |
| Vanguard Large Cap | 2,618,817,000 | 0 | 0.00% | 990,163,000 | 0 | 0.00% |
| Vanguard Growth | 10,368,985,000 | 519,571,000 | 5.01% | 8,295,074,000 | 1,428,133,000 | 17.22% |
| Vanguard Value | 13,254,049,000 | 961,457,000 | 7.25% | 5,945,162,000 | 750,250,000 | 12.62% |
| Vanguard Mid Cap | 20,625,448,000 | 755,146,000 | 3.66% | 16,176,663,000 | 1,955,471,000 | 12.09% |
| Vanguard Mid Growth | 2,688,721,000 | 171,959,000 | 6.40% | 2,300,322,000 | 338,953,000 | 14.74% |
| Vanguard Mid Value | 6,520,750,000 | 397,678,000 | 6.10% | 3,668,757,000 | 552,730,000 | 15.07% |
| Vanguard Small Cap | 17,786,079,000 | 0 | 0.00% | 11,420,569,000 | 0 | 0.00% |
| Vanguard Small Growth | 5,852,140,000 | 396,261,000 | 6.77% | 5,529,270,000 | 899,179,000 | 16.26% |
| Vanguard Small Value | 9,838,436,000 | 1,337,676,000 | 13.60% | 5,619,346,000 | 529,722,000 | 9.43% |
In-kind transactions (2016)
| Fund | Purchases | In-kind Purchases | Pct. Purchases | Sales | In-Kind Sales | Pct. Sales |
| Vanguard Total Market | 76,882,731,000 | 20,773,929,000 | 27.02% | 24,431,366,000 | 6,379,309,000 | 26.11% |
| Vanguard Large Cap | 2,618,817,000 | 1,529,947,000 | 58.42% | 990,163,000 | 364,717,000 | 36.83% |
| Vanguard Growth | 10,368,985,000 | 4,046,195,000 | 39.02% | 8,295,074,000 | 2,859,208,000 | 34.47% |
| Vanguard Value | 13,254,049,000 | 8,173,611,000 | 61.67% | 5,945,162,000 | 3,074,773,000 | 51.72% |
| Vanguard Mid Cap | 20,625,448,000 | 7,576,319,000 | 36.73% | 16,176,663,000 | 5,733,361,000 | 35.44% |
| Vanguard Mid Growth | 2,688,721,000 | 845,634,000 | 31.45% | 2,300,322,000 | 772,741,000 | 33.59% |
| Vanguard Mid Value | 6,520,750,000 | 2,609,330,000 | 40.02% | 3,668,757,000 | 1,527,892,000 | 41.65% |
| Vanguard Small Cap | 17,786,079,000 | 5,563,402,000 | 31.28% | 11,420,569,000 | 3,032,246,000 | 26.55% |
| Vanguard Small Growth | 5,852,140,000 | 1,720,019,000 | 29.39% | 5,529,270,000 | 1,386,204,000 | 25.07% |
| Vanguard Small Value | 9,838,436,000 | 4,557,464,000 | 46.32% | 5,619,346,000 | 2,078,604,000 | 36.99% |
US bond market index funds
In US bond market secondary trading, transaction costs are higher for corporate and municipal securities than for the more liquid US treasury market.
Harris (2015), in a study on corporate bond transaction costs, shows that transaction costs per bond decrease with trade size and increase with credit risk. Average transaction costs that customers incur when trading range between 84.5 basis points for retail size trades ($100,000 or less in par value) and 52.1 basis points for larger trades.
The first table shows the breakdown of government security and non-government security transactions in the 2016 fiscal year for Vanguard US bond index funds. The second and third tables provide cross trade and in-kind transaction data.
Government vs. Non-Government securities (2016)
| Fund | Purchases | Govt. Securities | Non-Govt. Securities | Sales | Govt. Securities | Non-Govt. Securities |
| Vanguard Short-Term | 28,373,970,000 | 21,065,900,000 | 7,308,070,000 | 24,419,743,000 | 19,269,457,000 | 5,150,286,000 |
| Vanguard Intermediate-Term | 21,963,130,000 | 14,234,945,000 | 7,728,185,000 | 15,507,966,000 | 11,111,509,000 | 4,396,457,000 |
| Vanguard Long-Term | 5,348,769,000 | 3,144,902,000 | 2,203,867,000 | 5,120,515,000 | 2,911,508,000 | 2,209,007,000 |
| Vanguard Total Bond | 126,615,300,000 | 105,753,569,000 | 20,861,731,000 | 101,319,305,000 | 89,911,748,000 | 11,407,557,000 |
Cross trading (2016)
| Fund | Purchases | Cross Purchases | Pct. Purchases | Sales | Cross Sales | Pct Sales |
| Vanguard Short-Term | 28,373,970,000 | 0 | 0.00% | 24,419,743,000 | 0 | 0.00% |
| Vanguard Intermediate-Term | 21,963,130,000 | 1,619,477,000 | 7.37% | 15,507,966,000 | 3,267,654,000 | 21.07% |
| Vanguard Long-Term | 5,348,769,000 | 263,801,000 | 4.93% | 5,115,375,000 | 1,147,034,000 | 22.42% |
| Vanguard Total Bond | 126,615,300,000 | 0 | 0.00% | 101,319,305,000 | 0 | 0.00% |
In-kind transactions (2016)
| Fund | Purchases | In-kind Purchases | Pct. Purchases | Sales | In-kind Sales | Pct. Sales |
| Vanguard Short-Term | 28,373,970,000 | 3,746,722,000 | 13.20% | 24,419,743,000 | 1,581,189,000 | 6.48% |
| Vanguard Intermediate-Term | 21,963,130,000 | 4,155,670,000 | 18.92% | 15,507,966,000 | 460,597,000 | 2.97% |
| Vanguard Long-Term | 5,348,769,000 | 609,686,000 | 11.40% | 5,115,375,000 | 800,829,000 | 15.66% |
| Vanguard Total Bond | 126,615,300,000 | 4,083,843,000 | 3.23% | 101,319,305,000 | 785,951,000 | 0.78% |
Tax-Exempt bond funds
Vanguard, in a 2017 white paper, A topic of current interest: Bonds or bond funds? provides the following transaction cost breakdown for tax-exempt municipal bonds.
| Trade size | Price bid ask spread |
| 0 to $49,999 | 134 |
| $50,000 to $99,999 | 100 |
| $100,000 to $1 million | 67 |
| More than $ 1 million | 20 |
The impact of trade size on transaction costs is noted in several other studies, including those by Harris and Piwowar (2004) and Chakravarty and Sarkar (2003).
The following table provides the 2016 fiscal year cross trades in the series of Vanguard tax-exempt bond funds.
Cross trading (2016)
| Fund | Purchases | Cross Purchases | Pct. Purchases | Sales | Cross Sales | Pct. Sales |
| Vanguard Short-Term | 3,709,642,000 | 907,225,000 | 24.46% | 2,978,530,000 | 1,506,683,000 | 50.58% |
| Vanguard Limited-Term | 5,183,119,000 | 1,279,902,000 | 24.69% | 2,545,098,000 | 754,616,000 | 29.65% |
| Vanguard Intermediate-Term | 13,113,694,000 | 2,134,576,000 | 16.28% | 4,394,114,000 | 1,141,431,000 | 25.98% |
| Vanguard Long-Term | 2,444,842,000 | 373,045,000 | 15.26% | 1,263,536,000 | 323,290,000 | 25.59% |
| Vanguard High Yield | 3,967,205,000 | 711,435,000 | 17.93% | 1,858,462,000 | 553,010,000 | 29.76% |
Addendum
The following tables show the combined percentage of cross trades and in-kind transactions in US stock index and US bond index funds.
US stock index funds (2016)
| Fund | Pct. Purchases | Pct. Sales |
| Vanguard Total Market | 27.02% | 26.12% |
| Vanguard Large Cap | 58.42% | 36.83% |
| Vanguard Growth | 44.03% | 51.69% |
| Vanguard Value | 68.92% | 64.34% |
| Vanguard Mid Cap | 40.39% | 47.53% |
| Vanguard Mid Growth | 37.85% | 48.33% |
| Vanguard Mid Value | 46.11% | 56.71% |
| Vanguard Small Cap | 31.28% | 26.55% |
| Vanguard Small Growth | 36.16% | 41.33% |
| Vanguard Small Value | 59.92% | 46.42% |
US bond index funds (2016)
| Fund | Pct. Purchases | Pct. Sales |
| Vanguard Short-Term | 13.20% | 6.48% |
| Vanguard Intermediate-Term | 26.29% | 24.04% |
| Vanguard Long-Term | 16.33% | 46.42% |
| Vanguard Total Bond | 3.23% | 0.78% |
Note
Computations compiled on Vanguard Cross Trading – 2016, google spreadsheet. Data derived from Vanguard fund annual reports.
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