Thus, the authors conclude: “We believe that less liquid portfolios have higher returns in equilibrium, not because they are more risky, but rather because they have higher transactions costs.” They further found that “less liquid portfolios also have low market betas, and long/short liquidity factors have negative market betas.”
Both Small- And Large-Cap Stocks
In addition, the authors show that liquidity isn’t just a proxy for size by constructing equally weighted, double-sort portfolios in capitalization and turnover quartiles. They found that in the smallest quartile of stocks, the low-liquidity portfolio earned a geometric mean return of 1.2 percentage points a year more than the high-liquidity portfolio. In large-cap stocks, the premium was an even greater 2.6 percentage points a year.
They found similar effects in value stocks. The highest returns were in portfolios that combine high-value with low-liquidity stocks, while the worst returns come from portfolios combining high-growth with high-turnover stocks.
The same results appeared when double-sorting momentum stocks. The highest returns come from combining high-momentum, low-liquidity stocks, and the worst returns come from low-momentum, high-liquidity stocks. Thus, liquidity is shown to be a unique factor.
Another finding was that liquidity is positively related both to momentum and value in the Fama-French four-factor model (beta, size, value and momentum), and negatively related to size and beta.
Worst Returns Were The Most Liquid Stocks
Finally, the authors found that the worst returns by far were for the high-liquidity, smallest-quartile stocks. The low-liquidity, smallest-quartile stocks provided annual average returns of 18.8 percent per year and geometric returns of 16.3 percent per year, and did so with a standard deviation of 23.6 percent.
The high-liquidity, smallest quartile stocks provided annual average returns of just 6.8 percent per year and geometric returns of just 1.5 percent a year, and did so with a standard deviation of 33.6 percent. It seems like screening out such stocks from a small-cap portfolio would be a worthwhile idea.
Forming the portfolios using equal weights tends to magnify the effects. But it also raises a question regarding exactly what amount of assets can be deployed in strategies that overweight smaller stocks. While the low-traded quartile comprises 25 percent of all stocks based on equal weighting, it will often contain only a small percentage of aggregate market capitalization.
However, as mentioned above, it does seem that screening out—or underweighting—high-liquidity stocks and overweighting the less popular, low-liquidity stocks could be a good idea in designing funds or portfolios. High-liquidity stocks, by definition, are popular, and popularity leads to cash flows, which in turn lowers returns.
In the end, there is ample evidence that liquidity is an economically significant and unique factor in long-run stock returns.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.