Isn’t it correct that if securities are large in number the impact cost will be large? hence the correct answer should be Fund 3.
Q. Which fund in Exhibit 1 most likely has the greatest implicit costs to implement its strategy?
- Fund 1
- Fund 2
- Fund 3
Solution
A is correct. Because Fund 1 has a large AUM but focuses on small-cap stocks, holds a relatively small number of securities in its portfolio, and prefers to make large trades, Fund 1 likely has the highest implicit costs. Each of these characteristics serves to increase the market impact of its trades. Market impact is a function of the security’s liquidity and trade size. The larger a trade size relative to a stock’s average daily volume, the more likely it is that the trade will affect prices. The relatively low level of trading volume of small-cap stocks can be a significant implementation hurdle for a manager running a strategy with significant assets under management and significant positive active weights on smaller companies.
Fund 3 has the small AUM , lets say $10M whereas fund 1 has high AUM let’s say $1Billion. Moreover the Fund 3 has large number of securities lets say 100 so even a small cap stock will less likely impacted due to the fund 3 purchase.
Whereas fund1 has small number of secuities lets say 20. The indiviual security will cover all most $50 million amount. And if such a purchase it made on a small cap stock then it will have a huge impact cost.