Swedroe: Ignore Liquidity At Your Peril

December 04, 2015

The International Evidence

Yakov Amihud, Allaudeen Hameed, Wenjin Kang and Huiping Zhang, authors of the study “The Illiquidity Premium: International Evidence,” which appeared in the August 2015 issue of the Journal of Financial Economics, contribute to the body of literature by examining the illiquidity premium—which the paper defines as the excess return on high-illiquidity stocks minus low-illiquidity stocks across volatility-based portfolios, or IML (the return on illiquid stocks minus the return on liquid stocks)—in stock markets in 26 developed-market countries and 19 emerging market countries. The data covers the 21-year period from 1990 through 2011.

Following is a summary of the authors’ findings, all of which are intuitive from a risk perspective:

  • As theory predicts, the illiquidity premium is positive and highly significant worldwide after controlling for global and regional common risk factors.
  • The average monthly IML is 0.77% for an equal return-weighted portfolio and 0.46% for a value-weighted portfolio. When adjusting for free-float, the IML was virtually unchanged.
  • IML is much higher (about twice as large) for emerging markets than it is for developed ones.
  • Median returns are very close to the mean returns, suggesting that the results are not generated by extreme cases (very thinly traded stocks).
  • The country-level illiquidity premium varies considerably over time. IML is higher when global market returns are lower, meaning liquidity is more valuable in bad times.
  • Global IML is significantly affected by credit conditions, measured by the U.S. yield spread between commercial papers and Treasury bills. The value of liquidity is positively affected by a rise in the credit spread, and is negatively affected by a decline in market prices. In other words, the illiquidity premium is higher during adverse market conditions. When market prices fall, traders need more funding to finance their positions, which become credit-constrained (for instance, due to margin calls). This forces them to liquidate their assets, which in turn makes liquidity more valuable.
  • Country-illiquidity premiums are lower in nations with better disclosure of corporate information and better governance rules and procedures. Better disclosure reduces information asymmetry between investors and corporate insiders, and should thus improve liquidity and reduce the illiquidity premium.
  • Firm size is associated with liquidity, suggesting that the size premium is due partly to the illiquidity premium. Size is a partial proxy for liquidity. On the other hand, there is no clear relation between the illiquidity premium and the value premium.
  • A country’s IML covaries positively with the global average IML after controlling for global and regional common risk factors. This reduces the ability to diversify against liquidity shocks.


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