Friction

• [TERM]: Friction
• [RELATED_TERM]: Transaction Costs
• [TERM_CATEGORY]: Investment Management

What Is Friction?

In finance, friction refers to any cost or impediment that reduces the efficiency or profitability of a financial transaction or investment. This encompasses a broad range of charges, expenses, and other factors that diminish net returns or impede capital flow. Friction is a core concept in Investment Management and is particularly relevant in the field of Portfolio Theory, where minimizing these costs is crucial for optimizing long-term performance. Understanding the various forms of friction is essential for investors seeking to maximize their investment outcomes.

History and Origin

The concept of friction in financial markets has evolved alongside the markets themselves. Historically, high fixed commissions charged by brokers represented a significant form of friction for investors. Before May 1, 1975, often referred to as "May Day," the New York Stock Exchange (NYSE) had a long-standing tradition of fixed-rate broker commissions, which meant that all brokers charged the same rates regardless of the trade size. This practice, rooted in the 1792 Buttonwood Agreement that established set commissions, limited competition and kept trading costs artificially high for investors¹⁶, ¹⁷.

The Securities and Exchange Commission (SEC) played a pivotal role in ending this practice. In the late 1960s and early 1970s, regulators began pushing for the abolition of fixed commissions, despite strong opposition from Wall Street. Ultimately, the SEC ordered that fixed commissions be abolished as of May 1, 1975, a move that dramatically reshaped the securities industry and paved the way for discounted brokerage services¹⁴, ¹⁵. This deregulation significantly reduced one major form of friction for investors, highlighting the ongoing effort to enhance market efficiency.

Key Takeaways

• Friction represents various costs and impediments that reduce financial transaction efficiency and investment returns.
• Common examples include trading costs (commissions, bid-ask spread), management fees, taxes, and inflation.
• Minimizing friction is critical for long-term investment success, as even small costs can significantly compound over time.
• Regulatory changes, like the abolition of fixed brokerage commissions, have historically reduced friction.
• Investors can mitigate friction through strategies such as selecting low-cost investment vehicles and tax-efficient investing.

Formula and Calculation

While there isn't a single universal formula for "friction" as a collective concept, its individual components, particularly fees, are often calculated as a percentage of assets under management (AUM) or a percentage of the transaction value.

For example, to understand the impact of an Expense Ratio (a common form of friction in funds) on an investment, the following can be considered:

Expected Return Net of Friction = Expected Gross Return - (Expense Ratio × Investment Amount)

Or, more broadly for an annual percentage fee:

Where:

• (\text{Net Return}) = The return after accounting for the fee.
• (\text{Gross Return}) = The return before accounting for the fee.
• (\text{Fee Rate}) = The percentage charged as a fee.
• (\text{Asset Value}) = The value of the investment on which the fee is based.

The cumulative impact of these fees over time can be significant, illustrating why seemingly small percentages of friction can have a large effect on overall Investment Performance.

Interpreting the Friction

Understanding friction involves recognizing its various forms and their cumulative impact on financial outcomes. A higher level of friction directly correlates with lower net returns for investors. For instance, a mutual fund with a high expense ratio will, all else being equal, deliver lower returns to its shareholders than a fund with a lower expense ratio. The Securities and Exchange Commission (SEC) mandates that mutual funds disclose their fees and expenses in a standardized fee table within their prospectus, allowing investors to readily compare these costs.¹¹, ¹², ¹³

Similarly, frequent trading in a Brokerage Account can incur substantial trading costs like commissions and bid-ask spreads, which are forms of friction that erode profits. Investors should assess the level of friction associated with any financial product or strategy and consider how it impacts their long-term Investment Horizon. Lower friction generally leads to more efficient capital allocation and potentially higher compounded returns over time.

Hypothetical Example

Consider an investor, Sarah, who has $10,000 to invest in a diversified Stock Portfolio. She is considering two options:

Option A: Actively Managed Mutual Fund

• Annual Expense Ratio: 1.0%
• Average Annual Gross Return (before fees): 7.0%

Option B: Low-Cost Index Fund

• Annual Expense Ratio: 0.1%
• Average Annual Gross Return (before fees): 6.9% (slightly lower gross due to passive strategy)

Let's look at the impact of friction over one year:

Option A (Actively Managed Fund):

• Gross return: $10,000 * 0.07 = $700
• Fees (friction): $10,000 * 0.01 = $100
• Net return: $700 - $100 = $600
• Ending balance: $10,000 + $600 = $10,600

Option B (Low-Cost Index Fund):

• Gross return: $10,000 * 0.069 = $690
• Fees (friction): $10,000 * 0.001 = $10
• Net return: $690 - $10 = $680
• Ending balance: $10,000 + $680 = $10,680

In this hypothetical example, even though the actively managed fund had a higher gross return, the significantly lower friction of the index fund resulted in a higher net return and ending balance for Sarah. Over many years, this difference would compound substantially, demonstrating the power of minimizing friction in a Long-Term Investment strategy.

Practical Applications

Friction appears in various aspects of investing, markets, and financial planning, and understanding its implications is crucial for investors.

• Investment Vehicles: Different investment vehicles inherently carry varying levels of friction. Actively managed mutual funds, for instance, typically have higher expense ratios and potentially higher Trading Costs due to frequent portfolio adjustments, compared to passively managed exchange-traded funds (ETFs) or index funds.⁹, ¹⁰ Morningstar data shows that the average fee for mutual fund investors has significantly declined over the past two decades, with a continued shift towards lower-cost options.⁸
• Taxation: Taxes are a significant form of friction, especially capital gains taxes on investment profits. Realized capital gains, which occur when an asset is sold for more than its purchase price, are subject to taxation. The rates can vary based on the holding period (short-term vs. long-term) and the investor's income.⁶, ⁷ Strategies like Tax-Loss Harvesting are employed to minimize this friction.
• Transaction Costs: Beyond explicit commissions, the Bid-Ask Spread is a form of implicit friction in financial markets. This is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. The wider the spread, the greater the friction for investors trading a security.
• Inflation: While not a direct fee, inflation acts as a pervasive form of friction, eroding the purchasing power of investment returns over time. A 3% annual inflation rate means that a nominal 5% return only yields a real 2% increase in purchasing power. Investors must strive for returns that outpace Inflation to preserve and grow their wealth.
• Regulation: Regulatory bodies, like the SEC, continually work to reduce friction by mandating transparency in fee disclosures and promoting fair market practices. For example, the SEC requires mutual funds to provide clear disclosure of all fees, including sales loads, redemption fees, and annual operating expenses, in their prospectuses and shareholder reports, which helps investors understand the total cost of their investments.³, ⁴, ⁵

Limitations and Criticisms

While minimizing friction is generally beneficial, a singular focus on eliminating all costs can have limitations. For example, some higher fees in actively managed funds may be justified if the fund manager consistently delivers Alpha (returns in excess of what would be expected given the risk taken). However, consistently achieving alpha after accounting for all forms of friction is challenging for many active managers.² A study found a negative relationship between fund fees and risk-adjusted returns for real estate funds, suggesting that higher fees do not always translate to better performance.¹

Another criticism arises when considering the quality of service. While discount brokers offer minimal friction in terms of commissions, they may not provide the comprehensive financial advice or personalized service that a full-service broker offers. For some investors, the value of Financial Advice or specialized research might outweigh the higher associated fees. Investors should also be wary of "hidden" friction, such as excessive portfolio turnover within a fund, which can generate significant transaction costs and capital gains distributions, even if the explicit expense ratio appears low. Understanding the full scope of costs, both explicit and implicit, is essential when evaluating the true friction of an investment.

Friction vs. Transaction Costs

While often used interchangeably in general discussion, "friction" is a broader term than "transaction costs" in finance. Transaction Costs are a specific type of friction directly associated with buying or selling securities. These include explicit costs like brokerage commissions and fees, as well as implicit costs such as the bid-ask spread and market impact (the effect a large order has on the price of a security).

Friction, on the other hand, encompasses all factors that diminish an investor's net return or impede financial efficiency. This includes transaction costs, but also extends to ongoing expenses like Management Fees, administrative fees, taxes (e.g., capital gains taxes), and even the eroding effect of inflation on purchasing power. Therefore, while all transaction costs are forms of friction, not all forms of friction are transaction costs. The distinction highlights that investors face a wider array of drags on their returns beyond just the immediate costs of trading.

FAQs

What are the main types of friction in investing?

The main types of friction in investing include explicit costs like brokerage commissions, sales loads (front-end or back-end), annual management fees, and other operating expenses (e.g., 12b-1 fees) within funds. Implicit costs include the bid-ask spread and market impact. Taxes, such as capital gains taxes, also represent a significant form of friction, as does the loss of purchasing power due to Inflation.

How does friction impact my investment returns?

Friction directly reduces your net investment returns. Even seemingly small percentages, such as a 0.5% annual expense ratio or a 0.25% trading commission, can compound over time to significantly diminish your overall portfolio value. The more friction present, the lower the actual wealth accumulation for an investor.

Can I completely eliminate friction from my investments?

No, it is generally impossible to completely eliminate all forms of friction from investments. Some level of cost is inherent in financial transactions and asset management, and taxes are typically unavoidable on realized gains. However, investors can significantly reduce friction by choosing low-cost investment products, minimizing unnecessary trading, and employing tax-efficient strategies such as investing in Tax-Advantaged Accounts where appropriate.

Why do some investments have higher friction than others?

Different investments carry varying levels of friction due to their structure, management style, and the services they provide. For example, actively managed funds generally have higher fees because they involve professional fund managers making investment decisions, conducting research, and engaging in more frequent trading, all of which incur costs. Conversely, passive Index Funds aim to replicate a market index, leading to lower management fees and trading costs, thus less friction.

How can I minimize friction in my portfolio?

To minimize friction in your portfolio, consider investing in low-cost index funds or exchange-traded funds (ETFs) with minimal expense ratios. Reduce unnecessary trading activity to lower commission costs and bid-ask spread impacts. Utilize Tax-Efficient Investing strategies, such as holding investments in tax-advantaged retirement accounts, and consider tax-loss harvesting where applicable. Regularly review your investment statements to understand all the fees and expenses you are paying.