Why Mutual Funds always invest in liquid stocks?

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.