Swedroe: Liquidity Key Price Factor

March 14, 2016

Liquidity—the ability to buy and sell significant quantities of a given asset, quickly, at low cost and without a major price concession—is valuable to investors. Therefore, they demand a premium as compensation for the greater risks and costs of investing in less liquid securities.

For example, liquidity risk partly explains the equity-risk premium. The average transaction costs on stock trades are far larger than they are on Treasury bills, which can be traded in large blocks of tens of millions of dollars in a single transaction without affecting their price.

The academic research has found that the illiquidity premium in stocks is positive and highly significant worldwide after controlling for global and regional common risk factors (such as beta, size and value).

Negativity Effect

Another important finding from the research is that the market requires a higher premium for liquidity sacrifice in negative environments, when investors holding illiquid equities become liquidity takers (divesting them, either to meet liquidity needs or due to panicked selling) and pay a steep price to do so. In other words, the liquidity premium is conditional on the state of the market—it’s much smaller in good times and much larger in bad times.

The finding of a liquidity premium is consistent with economic theory, which holds that assets that perform poorly in bad times (when marginal utility of consumption is higher) should carry large premiums. And what’s more, illiquid stocks (which tend to be smaller stocks) have greater sensitivity to liquidity shocks and thus also should carry premiums (helping to explain the size premium).

Stocks whose systematic liquidity risk rise more when funding illiquidity is worse have higher expected return. The finding of a liquidity premium also holds for corporate bonds. Corporate bond illiquidity increases monotonically when moving from safer bonds to riskier bonds, helping to explain their incremental yield.

Liquidity Preference

To summarize the theory and literature on equities and liquidity, investors care about stock illiquidity and thus demand higher expected returns on stocks that are more illiquid. Variations in illiquidity affect stock valuations.

Thus, investors not only prefer assets that are more liquid, they also prefer assets that have smaller exposure to liquidity shocks. In other words, they prefer assets whose prices fall less when market illiquidity rises, assets whose illiquidity rises less when market illiquidity rises, and assets whose illiquidity rises less when there is a marketwide decline in prices.

Yakov Amihud and Haim Mendelson—authors of the paper “The Pricing of Illiquidity as a Characteristic and as Risk,” which appears in the September 2015 issue of the Multinational Finance Journal—provide an excellent summary of the evolution of the research on liquidity.

In addition, through the use of the Amihud liquidity ratio (ILLIQ), which shows the amount of capital sufficient to change price by 1%, they show that there has been a strong and persistent downward trend in illiquidity since the early 1970s. However, the trend has been interrupted from time to time by bear markets, during which illiquidity rises.

For example, while the rise in illiquidity during the 2008-2009 financial crisis was quite strong, by the close of 2014, illiquidity was lower than ever before. The level of the log-ILLIQ fell from about 7 in the mid-70s to about 1 by the end of the period the authors examined. And over the last 10 years, it has fallen from about 2 to 1.

Liquidity Impacts Valuations

This is an important finding, because the sharp decline in illiquidity over the recent decades provides at least a partial explanation for the rise in equity valuations. As trading costs fall, the level of the equity risk premium should be expected to fall as well, resulting in (or justifying) rising valuations. The narrowing of bid/offer spreads and the dramatic fall in commission costs have helped improve liquidity, resulting in a smaller equity risk premium.

Amihud and Mendelson conclude it’s “the conditional illiquidity risk that is priced. Research on stocks and bonds shows that in periods with benign economic and market conditions, illiquidity risk isn’t priced, whereas in periods of adverse economic and market conditions, illiquidity risk is strongly and significantly priced.”

Two Important Takeaways

These findings should leave you with two important takeaways.

First, liquidity risk should be a consideration when designing your financial plan, both in terms of your asset allocation and the choice of investment vehicles.

Second, the liquidity premium for taking risk that shows up in bad times does have implications for the type of bonds used to implement the fixed-income portion of your portfolio.

The evidence presented highlights the importance of owning assets that perform well during bad times, when liquidity risks show up. Thus, you should strongly consider owning only safe, liquid bonds. U.S. Treasurys are the safest and most liquid of bonds.

As such, their diversification benefits tend to show up most strongly when needed most. While their correlation with U.S. stocks is about zero over the long term, during bear markets the correlation turns highly negative.

Other safe fixed-income investments you should consider are FDIC-insured CDs and municipal bonds that are rated AAA/AA and are also either general obligation bonds or essential service revenue bonds.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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