Level 3 – Equity Chapter 25 – Implicit costs and relation with AUM

CFA curriculum Reading 25 Item 6 (highlights are mine):

There are numerous costs that can affect the net performance of an investment product. The same investment strategy can easily cost twice as much to manage if a manager is not careful with her implementation approach. Assets under management (AUM) will affect position size. Position size and the liquidity of the securities in the portfolio will affect the level of turnover that can be sustained at an acceptable level of costs.35 Although smaller-AUM funds may pay more in explicit costs (such as broker commissions), <mark>these funds may incur lower implicit costs (such as delay and market impact) than large-AUM funds</mark>. Overall, smaller funds may be able to sustain greater turnover and still deliver superior performance. A manager needs to carefully weigh both explicit and implicit costs in his implementation approach.

So implicit costs are costs associated with large positions. CFA Institute cites two examples:

• Delay: When your position is large, it’ll take time to build your position. You can’t just put a huuuuuge bid in, because that’ll affect the price, which leads me to…
• Market Impact: when you’re a whale, any position change shifts the market itself, so you don’t realize as much profit when you have a massive selloff (price drops with your selloff), and don’t get as good a price when you buy in huge volumes (price increases when there’s a large buyup).

Small stock companies with large no of securities = small average positions

Small stock companies with small no of securities with large AUM = large average positions

Additional fun anecdote: I used to work managing positions for some startup billionaires, and they’re a good example of having a position that will have huge implicit costs if they decided to cash in their stock to buy a sweet Roman Abramovich yacht. And this is also an issue when they want to diversify, so they set up a private equity exchange club, where Elon calls up Jeff and Mark and say “Hey, I want some diversification, so let’s set up some contracts to swap some of our equity in our respective companies, but without actually going through the transactions.”

Smart diversification – without implicit costs.