What is Impact Cost – Effect of Impact cost on Mutual funds (Index Funds)

Impact cost can be defined as by how much large a buy/sell order increases/decreases price of scrip. This cost has more relevance to liquidity and has more effect on mutual funds (index funds especially).

For example a fund house wants to buy 1 lakh shares of XYZ Company. But at any point in time on the offer side of the order book there may not be a single for 1 lakh quantity. As you know the offer orders are placed in ascending order of prices.

Usually fund houses don’t disclose the order quantity at a time. Otherwise the price shoots  up immediately.  Assume the sell orders are in this range. 

 500   500.10
1000  500.40
2000  501.00
   …
   …

At this point in time there is a seller willing to sell shares at Rs500.10.  So the ideal price for the fund house to buy is 500.10. But it can’t get all the shares that it wants to buy at this price. Impact cost is calculated as the percentage of the difference of cost of acquisition and ideal price. Let’s say it got all the required shares at an average cost of Rs508.00 then the impact cost
in this case is
 (508.00 – 500.10)/500.10 * 100 = 1.58 %

In most liquid counters like Reliance and Larsen & Tubro there are always fair number of buyers and sellers available at any point in time and hence the impact cost would be less. The lesser the impact cost the less will be the cost of acquisition. This is the reason why Mutual Funds always prefer most liquid counters. Of course it should be able to sell immediately if investors want to redeem at any cost.

Why it is important for Index Funds?

An index fund is a replication of its benchmark. For example a Sensex based fund invests only in the shares of the companies that are part of Bombay Stock Exchange 30 share index, Sensex in the same proportion that they are in the index. So if the fund manager couldn’t get the shares at less impact cost the returns would substantially be lower compared to the actual index.
 

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Sathish Emmadi

Sathish Emmadi is a co-founder & editor at Lastbull.com. He is presently working in IT for one of the world’s top mutual fund companies. Handled multiple projects in BFSI (Banking,Financial Services and Insurance) domain. An Engineering Graduate from NITW.

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