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Why Mutual Funds always invest in liquid stocks?

August 18, 2012by Basavaraj Tonagatti

Today we will look for the reason behind mutual funds fund managers eagerness in investing in liquid stocks. It is interesting back end process which I thought to share with you.

First let us understand what is liquid stocks? In simple terms to say, liquid stocks are the stocks which have more buyers and sellers. This makes holder of stocks or buyer of stocks to easily either sell or buy it. Now let us understand one more definition called “Impact Cost”. This is not related to the cost what you pay for buying a stock like brokerage, transaction charges or depository charges. But the cost you pay for not finding desired quantity of stocks available in market.

Suppose Mutual Fund company decided to buy 1,00,000 stocks of XYZ company in stock market then usually they will not disclose quantity. Otherwise stock price will raise immediately. Instead what they will do is, look for the ideal price. If currently the best buy (bid) order is at Rs.99 and sell(ask) is at Rs.101. Difference between these two is called bid ask price, which currently is Rs.2. Suppose someone try to buy 100 stocks at 101 and sell immediately at 99 then they will loose Rs.2 for each stock they purchased. Ideal price in above case is considered as Rs.100 which is middle price of best buy and best sell price.

But if mutual fund company not found the desired quantity of 1,00,000 then they need to purchase part by part by considering the ideal price each time. So if the average purchase price of all 1,00,000 raised to Rs.101.50 then the impact cost is calculated as below.

Ideal price (average price between best buy and best sell order) Rs.100 and average price bought is Rs.101.50 Then Impact Cost is

(101.50 – 100)/100 * 100 = 1.50%.

What this 1.50% significe is, mutual fund company paid 1.50% more than the ideal price due to non availability of desired quantity in XYZ stock. If all the 1,00,000 quantity available then the trade might have done at Rs.100 which saved mutual fund company by paying 1.50% more than the ideal price. This additional cost is called Impact Cost.

So more liquid stocks means less Impact Cost where as lesser liquid stocks means higher Impact Cost. This is the main reason why mutual funds always looks for liquid stocks to reduce their Impact Cost.

Impact Cost will play a major role in case of Index Funds. Because Index Funds always replicate the Index which they benchmarked. If they are unable to find the required quantity of Index Stocks then obviously Impact Cost will increase, which will automatically impact on fund performance and deviates more from Index returns.

Category: Investment Planning, Mutual FundTag: Impact Cost, Liquid Stocks

About Basavaraj Tonagatti

Basavaraj Tonagatti is the man behind this blog. He is SEBI Registered Investment Adviser who is practicing Fee-Only Financial Planning Process and also an Independent Certified Financial Planner (CFP), engaged in blogging since 7 years. BasuNivesh blog is ranked as one among India's Top 10 Personal Finance Blog. He is not associated with any Financial product/service provider. The purpose of this blog is to "Spread personal finance awareness and make them to take informed financial decisions." Please note that the views given in this Blog/Comments Section/Forum are clarifications meant for reference and guidance of the readers to explore further on the topics/queries raised and take informed decisions. These should not be construed as investment advice or legal opinion."

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Reader Interactions

Comments

  1. Bhavesh

    May 16, 2016 at 4:25 PM

    Hi sir ,

    Any suggestion for 5 year – 3000 per month investing in SIP MID CAP.
    I want better return.

    Reply
    • Basavaraj Tonagatti

      May 17, 2016 at 7:39 AM

      Bhavesh-No equity for 5 years term.

      Reply
  2. Himanshu

    May 16, 2016 at 1:15 PM

    Hi sir ,

    My name is himanshu & i want to invest in SIP- 2000 per month
    which one is better for 3 year with max return.
    Please suggest me

    Reply
    • Basavaraj Tonagatti

      May 16, 2016 at 1:19 PM

      Himanshu-NO Equity Investment for 3 years period.

      Reply
      • Himanshu

        May 16, 2016 at 2:16 PM

        Any Mid cap / small cap for 5 Year.

        Reply
        • Basavaraj Tonagatti

          May 17, 2016 at 7:58 AM

          Himanshu-NONE.

          Reply
  3. Ravi

    August 21, 2012 at 4:31 PM

    Hi Basu Nivesh,

    One question is how to sell mutual funds ?

    Is it as easy as selling Shares ?

    Best Regards
    Ravi

    Reply
    • BasuNivesh

      August 21, 2012 at 6:12 PM

      Ravi-Yes selling is easy. I think you compared with selling of stock. Selling of stock is different thing where you need to get matching order to sell. But in mutual funds, you are selling them back to mutual fund companies.

      Reply

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