Warning! Even “large cap” stocks are not liquid enough! Can you handle this?

Last Updated on December 29, 2021 at 12:58 pm

Stock investors would be well aware of a small difference between the buy-price and sell-price of a share, known as the bid-ask spread. This “cost” or “loss” (applicable for an immediate buy and sell) is inevitable and quite different from brokerage costs. The price difference is a measure of liquidity in the market. The bid-ask spread applies only for small quantities of stocks purchased or sold. Institutional investors (including mutual fund managers) face different liquidity constraints. We discuss why even the so-called large cap stocks are not liquid enough and pose difficulties for mutual fund managers.

When one needs to buy/sell huge quantities of a share, it will have to be done in lots as determined by the stock exchange “order book”. Since the bid-ask spread applies to only the first lot of shares, large transactions use a different measure of liquidity known as impact cost. This is best explained via an example.

What is impact cost?

The following example has been derived from the NSEs impact cost definition page. Suppose the stock exchange order book at some instant of time look like this

The quantity of shares for buying and selling will be different but we have assumed it to be the same to keep things simple. Suppose I want to buy 2000 shares, ideally, I should be able to all of them at the selling price of Rs. 102. Since the buying price is Rs. 100 the bid-ask spread is only Rs 2. So we first define the ideal buying price as (102+100)/2 = 101

However, I can only buy 1000 shares in one lot at Rs. 102. The second lot of 1000 shares will be purchased at Rs. 103 (assume instant buys). So the average buying price for this trade is:

[(1000 x102) + (1000 x 103)]/2000 = 102.5

This Rs. 102.5 is 1.5% higher than the ideal buying price of Rs. 101. This 1.5% is known as the impact cost (for buying).

Impact cost is dynamic and depends on the quantity of shares involved in the transaction. There is a separate impact cost of buying and selling. The exchange can impost a penalty in case the stock is not liquid enough resulting in a higher cost.

Impact cost of Nifty 50 stocks (March 2019)

The NSE publishes impact cost for Nifty 50 and Nifty Next 50 each month. For a stock to be eligible for inclusion in the Nifty 50, its impact cost should be 0.5% or less for 90% of its transactions. The Nifty has a weighted average impact cost for a portfolio of Rs. 50 Lakh = 0.02%

No stock in the Nifty 50 (at the time of writing) has an impact cost two standard deviations above the average (not weighted). However, no stock has an impact cost lower than two standard deviations from the average. This means that no stock in the NIfty has exceptional liquidity. Amusingly the stock with the highest weight in the Nifty, HDFC Bank has twice the impact cost of Reliance Industries Ltd. (second highest in weight).

While one can approximately say, lower the weight in the Nifty, higher the impact cost, higher the loss when large quantities are transacted and lower the liquidity, it is not rigorously true.

Please take a moment to recognise the dificulty of Nfity 50 Equal weight index fund manager vs a Nifty 50 Index fund manager. The former will have a tough time tracking the index as the AUM increases.

Impact cost of Nifty Next 50 stocks (March 2019)

The NIfty Next 50 has a weighted average impact cost of 0.04% for a portfolio of Rs. 25 Lakh. This is 2X the impact cost of Nifty 50 for 0.5X the portfolio size!! Again proof of the earlier warning issued: Nifty Next 50 is NOT a large cap index!

Most of the Nifty Next 50 stocks have an impact cost at least twice that of Nifty 50.

Most illiquid “large cap” stocks (March 2019)

If you combine Nifty and Nifty Next 50 these these stocks have an impact cost greater than two standard deviations above the (unweighted) impact cost!!

Now imgaine the plight of the two Nifty 100 Equal Weight Index fund manages (from Principal and Sundaram). They would have a pretty tough time tracking the Index. The same could be true of the Nifty LargeMidcap 250 Index (IF and when it is announced by Motilal Oswal)

Impact cost vs Free float market cap of NIfty 100 stocks

If we combine the above data, it can be seen that there is a step wise increase in impact cost as the free float market cap decreases.

If we define impact costs of 0.04 and above as “expensive” then at least 25% of the “large cap universe” as defined by SEBI  has significantly lower liquidity than top 75% (in terms of free float market cap).

What does this mean? How does it affect me?

Imagine if there is a huge sell-off resulting in plunging prices. This lack of liquidity will result in big losses for a Nifty Next 50 Index (or ETF) investor. The same is true of midcap and small cap mutual funds too. If you want to invest in more of these, then be prepared for huge volatility. Most people who talk about having a “high-risk appetite” have never seen big market falls. I have already shown how Nifty Next 50 is a lot more volatile than Nifty: Warning! Nifty Next 50 is NOT a large cap index! This article ties up to the risk to the relative lack of liquidity.

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