Understanding Economies of Scale: Liquidity Costs

I’m usually pretty supportive of Mutual Funds in my articles, but that doesn’t mean that they’re perfect. Because we’re talking about how economies of scale impact funds or comparable portfolios, it’s important that we examine the downside risks of a fund. Specifically, I’m going to take this opportunity to describe how it is that the scale benefits of a fund that saved you hundreds of dollars on a portfolio can come back and cost you everything as well.

In the first section of this series I described how it is that a fund’s ability to purchase great volumes of a security can create an incremental cost saving for you as an investor. However, this exactly same benefit comes back to haunt you when it comes time for the fund to sell off securities. When a fund decides that it is time to liquidate a position, it will have a great deal of difficulty finding a buyer that is powerful enough to take on hundreds of millions of dollars worth of positions all at once.

If the fund did manage to find someone with deep enough pockets to do so, it would likely be at an extremely deep discount, and therefore have an extremely negative impact on the fund’s total returns. Remember, Bid/Ask prices work both ways. If an investor wants to buy many securities at once, they will receive a great discount. Alternatively, if an investor wants to sell many securities at once, they will need to provide a great discount. It is for this reason that mutual funds must be long-term investments, because they cannot liquidate their holdings very quickly in short-term markets.

Imagine a situation where a small-cap fund has purchased a large amount of equity in a promising upstart company. The fund receives a fantastic price on the stock because they buy in large volume, and the manager is confident in the long-term ability of management to perform. Other investors in the market see that a respectable mutual fund has bought shares in the upstart, and they follow-suit because they like the implications. The stock performs admirably for two years, and the investors are all happy with their returns. However, the small-cap stock has so greatly out-performed the mutual fund’s other holdings that it needs to scale back to stay properly diversified.

The fund begins submitting incremental orders to sell off its position, and thereby securing a capital gains distribution for the unit holders. Unfortunately, the other investors that bought in conjunction with the fund see that the fund is now selling out, and all begin to start taking their own profits as well. The stock suddenly begins to quickly drop, as many investors begin trying to sell in conjunction with the fund.

While the investors will likely manage to retain the majority of their profits due to the small size of their positions, the mutual fund will be stuck with millions of dollars in shares well after the smaller investors have liquidated their own holdings. While the value of the overall position is still greater than the purchase price, the returns realized by the small investors were much greater than the fund, because they were able to get out of their position much more quickly.

So how do we quantify this kind of risk? We don’t really, not unless you’re a math wizard with a couple of free weekends to crunch numbers on. But this liquidity risk does present a simple deciding factor for us to evaluate our portfolios on. Based on this week’s series, we can deduce the following basic functions of funds and individual portfolios.

  • Mutual funds are better suited for our long-term holdings, because the long-term returns are less expensive to purchase, and more effectively realized. This is due to their better purchasing capacity.

  • Mutual funds are better suited for providing diversification because they are better able to handle transaction costs/commissions.

  • Individual portfolios are better suited for timing a market, because they are more liquid.

  • Individual portfolios are better suited for trading securities with small volumes because they have less of an impact on price, and are more flexible due to small volume amounts.