Swedroe: Liquidity Premium Diminishing

Liquidity can be described as the ability to trade a large number of investments quickly, at low costs and when you want to.

Because it is a priced risk, liquidity and its associated price effects are an important aspect of financial markets.

In illiquid markets, such as the private equity market, discounts are large and pervasive. Publicly traded equity, however, is generally more liquid. As a result, it’s important to understand the size of the liquidity premium associated with publicly traded stocks, and whether it’s economically significant.

Liquidity Evolving

Of particular interest to investors is that over the last 40 years, we’ve seen many technological innovations (such as high-frequency trading) and regulatory changes (such as decimalization) that may have contributed to improving liquidity in financial markets by lowering bid/offer spreads.

The dramatic expansion of the hedge fund industry, which now has approximately $3 trillion in assets under management, may also have had an impact on market liquidity. It’s possible that hedge funds, many of which act as long-horizon traders and thus incur relatively small transaction costs, might have arbitraged away (or at least reduced the size of) the liquidity premium by purchasing illiquid stocks and short-selling liquid stocks.

Financial innovation, in the form of low-cost index funds and ETFs, may also play a role in affecting the liquidity premium. The presence of such instruments allows investors to buy and sell illiquid assets indirectly, lowering the sensitivity of returns to liquidity.

Investors are able to obtain illiquid stocks indirectly for very low transaction costs, prolonging the investment horizon of the marginal investor that holds illiquid stocks and thereby reducing the sensitivity of returns to liquidity.

Premium Put To Test

How have all these developments impacted the liquidity premium? Have they caused the liquidity premium to shrink, or even vanish? In their study, “The Diminishing Liquidity Premium,” Azi Ben-Rephael, Ohad Kadan and Avi Wohl sought answers to these questions.

Their paper, which appears in the April 2015 issue of the Journal of Financial and Quantitative Analysis, used a data set incorporating stocks traded on all three major exchanges. For NYSE stocks, the sample period is from 1931 through 2011; for AMEX stocks, the sample period is from 1964 through 2011; and for Nasdaq stocks, the sample period is from 1986 through 2011.

2 Types Of Liquidity Premiums

The authors begin by explaining that there are two types of liquidity premiums. The first they refer to as a characteristic liquidity premium, which is associated with the transaction costs of trading in the security.

The second is a systematic liquidity premium, which is associated with the sensitivity of stock returns to shocks in market liquidity. It’s the risk that a firm’s stock price will decline in conditions where market liquidity is low. The authors noted that the two types of premiums aren’t necessarily related and may exhibit different trends.

In analyzing liquidity’s influence, the authors used three measures, each of which captures a different aspect of liquidity. The first is a measure of price impact, calculated as the annual average of daily absolute return to dollar volume. The second is a measure of the bid/offer spread. The third measure combines both these facets of liquidity and measures the price impact of the spread to annual dollar volume.

The Findings

Following is a summary of the authors’ findings:

• The characteristic liquidity premium on all three U.S. exchanges has significantly declined over the past four decades. It was large and robust until the mid-1980s, but has become small and “second order” since. For example, for common stocks listed on the NYSE, the equally-weighted average annual characteristic liquidity premium of one measure declined from roughly 1.3 percent in the period from 1964 through 1975 to insignificant levels in the period from 2000 through 2011.
• For smaller stocks, there’s a characteristic liquidity premium in early periods, but it declines significantly and largely disappears later on. This holds true among all three exchanges. The premium is concentrated primarily in small stocks on the Nasdaq, whose market value accounts for only about 0.5 percent of the total market value of all publicly listed common stocks. There’s a characteristic liquidity premium among “penny stocks,” defined as those stocks with a price below $2. However, the market cap commanded by these penny stocks accounts for just 0.2 percent of the stock sample’s total market cap. To the extent that a characteristic liquidity premium currently exists in the U.S. public equity market, it’s economically small.
• The decline in the liquidity premium stems from an improvement in market liquidity, and from a lower sensitivity of expected returns to liquidity. This finding is consistent with markets having become more efficient following more intense arbitrage activity.
• There is no evidence of a systematic liquidity premium among NYSE and AMEX stocks. However, there’s an economically significant premium among Nasdaq stocks, and it hasn’t been trending downward.
• The strategy of buying illiquid stocks and selling liquid stocks has lost much of its profitability over the years. The abnormal returns associated with such a strategy in recent periods have become insignificant except for small-sized stocks listed on Nasdaq, which account for just 0.3 percent of the total market cap.
   

Impact To Valuations

The authors noted their results have important implications for equity valuations. They write: “A reduction of the average annual liquidity premium from 1.8 percent to 0 percent implies a very large price effect.” All else equal, a smaller liquidity premium justifies a lower equity risk premium, providing support for higher valuations.

The authors observe: “A 1 percent decrease in the discount rate may translate into a 10 percent-20 percent increase in valuation.” The decline in the liquidity premium may also help explain the shrinking small-cap premium, about which much has been written.

In terms of asset management strategies, the findings in this study cast doubt on the liquidity-based, long/short trading strategies that have become common for hedge funds.

In closing, the authors did emphasize that their results are based on data only from domestic stock markets. Our equity markets are probably the most liquid markets in the world, and it’s likely that liquidity pricing is more significant in less liquid markets internationally.

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