What Is Operational Efficiency?
Operational efficiency is primarily a metric that measures the efficiency of profit earned as a function of operating costs. The greater the operational efficiency, the more profitable a firm or investment is. This is because the entity is able to generate greater income or returns for the same or lower cost than an alternative.
In financial markets, operational efficiency occurs when transaction costs and fees are reduced.
- Operational efficiency measures the proportion of costs incurred during an economic or financial activity, where lower costs equate with greater efficiency.
- For investors and traders, markets exhibit operational efficiency when transaction costs are low.
- Offering bulk discounts or free commissions to traders is one way to increase the operational efficiency of investment markets.
Understanding Operational Efficiency
Operational efficiency in the investment markets is typically centered around transaction costs associated with investments. Operational efficiency in the investment markets can be compared to general business practices for operational efficiency in production. Operationally efficient transactions are those that are exchanged with the highest margin, meaning an investor pays the lowest fee to earn the highest profit. Similarly, companies seek to earn the highest gross margin profit from their products by manufacturing goods at the lowest cost. In nearly all cases, operational efficiency can be improved by economies of scale. In the investment markets, this can mean buying more shares of an investment at a fixed trading cost to reduce the fee per share.
A market is reported to be operationally efficient when conditions exist allowing participants to execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. Operationally efficient markets are typically a byproduct of competition which is a significant factor improving the operational efficiency for participants. Operationally efficient markets may also be influenced by regulation that works to cap fees in order to protect investors against exorbitant costs. An operationally efficient market may also be known as an "internally efficient market."
Operational Efficiency and Investment Firms
Operational efficiency and operationally efficient markets can help to improve the overall efficiency of investment portfolios. Greater operational efficiency in the investment markets means capital can be allocated without excessive frictional costs that reduce the risk/reward profile of an investment portfolio.
Investment funds are also analyzed by their comprehensive operational efficiency. A fund’s expense ratio is one metric for determining operational efficiency. A number of factors influence the expense ratio of a fund: transaction costs, management fees, and administrative expenses. Comparatively, funds with a lower expense ratio are generally considered to be more operationally efficient.
Productivity vs. Efficiency
Productivity serves as a measurement of output, normally expressed as some units per amount of time (for example, 100 units per hour). Efficiency in production most often relates to the costs per unit of production rather than just the number of units produced. Productivity versus efficiency can also involve analysis of economies of scale. Entities seek to optimize production levels in order to achieve efficient economies of scale, which then helps to lower per-unit costs and increase per-unit returns.
Investment Market Examples
Funds with greater assets under management can obtain greater operational efficiency because of the higher number of shares transacted per trade. Generally, passive investment funds are typically known to have greater operational efficiency than active funds based on their expense ratios. Passive funds offer targeted market exposure through index replication. Large funds have the advantage of economies of scale in trading. For passive funds, following the holdings of an index also incurs lower transaction costs.
In other areas of the market, certain structural or regulatory changes can make participation more operationally efficient. In 2000, the Commodity Futures Trading Commission (CFTC) passed a resolution allowing money market funds to be considered eligible margin requirements. (Prior to this only cash was eligible.) This minor change reduced unnecessary costs of trading in and out of money market funds, making the futures markets more operationally efficient.
Financial regulators have also imposed an 8.5% sales charge cap on mutual fund commissions. This cap helps to improve operational trading efficiency and investment profits for individual investors.