What is operational efficiency?
Operational efficiency is mainly a measure that measures the effectiveness of the profits made as a function of operating costs. The greater the operational efficiency, the more profitable the business or investment. This is due to the fact that the entity is able to generate higher income or returns for the same cost or a lower cost than that of an alternative. In financial markets, operational efficiency occurs when transaction costs and fees are reduced.
Key points to remember
- Operational efficiency is a measure of the amount of costs incurred during a given economic or financial activity, where lower costs equate to 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.
Understand operational efficiency
Operational efficiency in investment markets is generally centered on the transaction costs associated with investments. Operational efficiency in investment markets can be compared to general business practices in operational efficiency in production. Operationally efficient transactions are those that are traded with the highest margin, which means that an investor pays the lowest fees to make the highest profit. Likewise, companies seek to derive the highest gross profit from their products by manufacturing goods at lower cost. In almost 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 in order to reduce the costs per share.
A market would be operationally efficient when conditions exist for participants to execute transactions and receive services at a price that equitably equates to the actual costs necessary to provide them. Operationally efficient markets are generally a byproduct of competition which is an important factor improving the operational efficiency of participants. Operationally efficient markets can also be influenced by regulation that seeks to cap fees to protect investors from exorbitant costs. An operationally efficient market can also be called an “internally efficient market”.
Operational efficiency and operationally efficient markets can help improve the overall efficiency of investment portfolios. Greater operational efficiency in investment markets means that capital can be allocated without excessive friction costs that reduce the risk / return profile of an investment portfolio.
Investment funds are also analyzed by their overall operational efficiency. A fund’s expense ratio is a measure of operational efficiency. A number of factors influence a fund’s expense ratio: transaction costs, management fees and administrative fees. In comparison, funds with a lower expense ratio are generally considered to be more operationally efficient.
Productivity vs efficiency
Productivity is used to measure production, normally expressed in units per amount of time (for example, 100 units per hour). Production efficiency most often relates to costs per unit of production rather than the number of units produced. Productivity versus efficiency can also involve an analysis of economies of scale. The entities seek to optimize production levels in order to achieve efficient economies of scale, which then reduces unit costs and increases unit yields.
Examples of investment markets
Funds with larger assets under management may achieve greater operational efficiency due to the higher number of shares traded per transaction. Generally, passive investment funds are generally known to have greater operational efficiency than active funds based on their expense ratios. Passive funds offer targeted market exposure through the replication of the index. Large funds have the advantage of economies of scale in trade. For passive funds, monitoring the holding of an index also leads to lower transaction costs.
In other areas of the market, certain structural or regulatory changes can make participation more effective operationally. In 2000, the Commodity Futures Trading Commission (CFTC) adopted a resolution allowing money market funds to be considered as eligible margin requirements. (Before that, only cash was eligible.) This minor change reduced unnecessary costs of trading in and out of money market funds, making futures markets more operationally efficient.
Financial regulators have also imposed an 8.5% cap on sales commissions on mutual funds. This cap helps to improve operational business efficiency and investment benefits for individual investors.