Understanding Economies of Scale: Brokerage Commissions

The other day I received a question at work about how it is that a mutual fund or ETF can provide an investor with scale in an investing portfolio. The asking party was mainly curious about how it is that the diversification benefits of a fund can outweigh the liquidity that an individual investor has. He had a point really.

Why is it that an investor can’t just replicate a mutual fund’s holdings and save on management expenses? Over the course of the week, I’m going to explain the three main implications of scale in an investment portfolio, and how it is that your mutual fund or ETF either protects you or exposes you to economies of scale.

I find that one of the most confusing things to keep in mind about stock prices is that the ‘last traded price’ (the price most cited as being the active price of the security) does not actually represent the price which an investor receives or pays during a transaction. In most cases, this price will be as much as 2-5 cents (less than a percentage point) off from the actual price realized.

However, as volumes decrease (maybe because we’re looking at less liquid products such as small-caps or derivatives) that price discrepancy can increase to be as much as 2-5% of your purchase price. When you start looking into the options markets, the volatility of the securities creates an even greater ‘spread’ between these prices. Why does this happen you ask? The answer is fairly straight forward, but its implications are less so.

The Bid-Price represents the price at which other investors are currently willing to purchase a given security at that exact moment. If you are selling a security into the market, you will likely receive the Bid-Price. The Ask-Price represents the price at which investors are willing to sell a given security at that exact moment. If you are buying a security, you will likely receive the Ask-Price.

Understanding this, it is important to understand that the Ask will be higher than the Bid, because investors always want to sell at a price higher than they bought at. Unfortunately, arbitrage opportunities using this spread are generally only available to large institutional ‘market-makers’, who generally establish what the price of a security will be by both buying and selling it at the same time.

So what kind of impact does a Bid/Ask spread have on deciding whether or not you should buy into a mutual fund instead of taking on the holding yourself? The answer involves those market makers I mentioned briefly above. When a market maker offers to sell at an Ask price, they are doing so under the assumption that they will be selling in small lots of 100 units at a time. However, if a fund with hundreds of millions of dollars in assets were to approach them and ask for a price quote for purchasing a very large order of a given security, you’d better believe that the market maker will quote a better price than the listed Ask. Simply put, the market maker earns a larger nominal profit on the transaction, even though the percentage is smaller. So what does this mean to us small-time investors?

If we look at the break-even equation of a mutual fund against a personal investor, the mutual fund automatically has a lower break-even price than the investor because they would have paid less for the units they acquired. This means that the fund makes a profit before the investor does, because of the difference in operating costs associated with each. While this is a trivial matter for huge stocks like Microsoft and Exxon Mobil, it because a larger issue for securities with less volume.

If an investor wants to get a bit more aggressive with their portfolio at all, or if they want to engage in some short-term trading, they need to be entirely sure of the value of their position, because they are taking on an immediate loss as soon as they enter into that position. This is as opposed to the better positioned risk-adverse investor, which has minimized their purchasing risk by entering an aggressive market by buying shares in a small-cap fund.