Swedroe: Targeting Liquidity As A Style

There’s a clear relationship between low-liquidity stocks and higher returns.

During the financial crisis of 2008, even sophisticated investors such as the Yale Endowment fund learned just how expensive liquidity can be when you need it most. So it should come as no surprise that less liquid stocks have outperformed more liquid ones.

There’s a logical, risk-based explanation for that outperformance. Investors demand a premium for taking liquidity risk. Less liquid stocks not only take longer to trade, but transaction costs are likely to be higher as well. That’s especially true if you must purchase liquidity during times of stress in the markets. Thus, investors with long horizons, who are also willing to trade less frequently, can earn an expected risk premium.

Roger G. Ibbotson and Daniel Y.-J. Kim—authors of the July 2014 study “Liquidity as an Investment Style: 2014 Update”—examined whether liquidity as an investment style meets the four criteria set down in 1992 by Nobel Prize winner William Sharpe.

According to those criteria, a benchmark investment style must be: identifiable before the fact; not easily beaten; a viable alternative; and low in cost. Using stock turnover as a measure of liquidity, the study analyzed the top 3,500 U.S. stocks from 1971 through 2013. Following is a summary of the authors’ findings:

• First, the previous year’s turnover of stocks is identifiable before the fact. It’s also simple, easy to measure and has a significant impact on returns.
• Second, liquidity is a distinct and viable alternative to the factors of size, value and momentum, because its impact is additive to each of them.
• Third, first-quartile portfolios constructed using liquidity, momentum, size and value investment styles outperform the equally weighted universe portfolio.

1. The low-liquidity quartile portfolio outperforms both the smallest-cap portfolio and the high-momentum portfolio, producing returns that are indeed “hard to beat.”
2. The low-liquidity portfolios also generate statistically significant alphas in Fama-French four-factor models. The authors also found that as less liquid stocks become more liquid, their returns increase dramatically, and vice versa.
3. However, migration cannot be known ex-ante. They write: “Nevertheless, these results demonstrate that changes in liquidity strongly correlate with changes in valuation.”

• Fourth, forming portfolios once a year resulted in 78 percent of the high-performing, low-liquidity quartile of stocks remaining in that quartile. Thus, the liquidity portfolio doesn’t exhibit high turnover, helping to keep costs low. That’s especially true if one is a patient trader and refrains from forcing trades, such as index funds do on reconstitution dates.

Interestingly, the authors also found that there’s “little evidence that styles are related to risk, at least as measured by standard deviation.” For example, for value and momentum, the first quartile is less risky than the fourth-quartile portfolio.

Only for size is there a clear risk dimension: The smaller the capitalization, the larger the standard deviation. For liquidity, there is an inverse relationship between returns and risk, with the low-liquidity portfolio having the highest return but the lowest risk.

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.