Implications Involving Cost

Implications Involving Cost

Implicit Vs. Explicit Costs

Implicit trading costs are also known as opportunity costs and include market impact costs. When a manager sells a significant amount of stock, the increased selling pressure can push down the security's price, resulting in a lower return for the sale.

Market impact costs are influenced by:

  • Assets under management (AUM): Smaller-cap securities may have limited trading volume, which can be problematic for portfolios with high AUM. Larger portfolios may not be able to transact sizable amounts of security without affecting their price significantly.
  • Turnover: Higher turnover leads to increased transaction costs and a greater potential for moving security prices unfavorably.
  • Information-motivated trades: Managers can unintentionally reveal information through their trades. For instance, if a large fund starts buying substantial amounts of stock, the market may interpret this as a positive signal, assuming the fund possesses undisclosed information.

Slippage refers to the difference between the execution price and the midpoint of the quoted bid-ask spread when the trade was initiated. Slippage costs typically:

  • Exceed explicit costs.
  • Are higher for small-cap securities compared to large-cap ones.
  • Are not necessarily greater in emerging markets.
  • Significantly rise with increased market volatility.

These factors imply that successful small-cap managers might struggle to scale their AUM due to growing slippage costs, while large-cap funds can more readily support increased AUM.

Question

Which of the following statements regarding slippage costs is least likely to be accurate?

  1. Slippage costs are generally higher for small-cap securities than for large-cap securities.
  2. Slippage costs are not necessarily higher in emerging markets.
  3. Slippage costs are substantially lower with increased market volatility.

Solution

The correct answer is C.

Option C is correct. Slippage costs tend to be higher with increased market volatility, not lower. This is because volatile markets can lead to larger price swings and increased potential for execution at less favorable prices due to rapid market movements.

A is incorrect. The statement is generally accurate. Small-cap securities often have lower liquidity, which can result in larger price fluctuations when trading, leading to higher slippage costs.

B is incorrect. The statement is generally accurate as well. Slippage costs can vary depending on various factors, and while emerging markets might have higher volatility, they can also have lower trading volumes, potentially affecting slippage costs in different ways.

Reading 26: Active Equity Investing: Portfolio Construction

Los 26 (f) Discuss how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions

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