How liquidity risk affects global stock returns
(MoneyWatch) Liquidity is an important characteristic of U.S. stocks and bonds. There's increasing evidence that less-liquid, publicly traded securities outperform more liquid ones.
Roger Ibbotson and Wendy Hu of Zebra Capital Management add to the literature on the impact of liquidity on investment returns with a paper that examines results across the globe. Their study covered the period from December 1995 through 2010 and over 6,000 stocks in the developed markets, including the U.S., U.K., Japan, and eurozone countries. The following is a summary of their findings:
- Liquidity is a strong predictor of future returns in U.S., international and global markets, yet distinct from the beta, size, value and momentum factors.
- Across the small-size quartile, the low-liquidity group earns a geometric average return of 13.5 percent a year while the high-liquidity group 7.3 percent a year, a liquidity effect of 6.2 percent.
- Across the large-size quartile, the low- and high-liquidity groups, respectively, earn 12.2 percent and 8.7 percent, producing a liquidity effect of 3.5 percent.
- Within the two midsize groups, the liquidity return spread is also significant.
- Size doesn't capture liquidity -- the liquidity effect holds regardless of the size group. However, the liquidity effect is the strongest among the smallest size stocks and declines across the quartiles from small to large-size stocks.
- For high-growth stocks, the low-liquidity stock portfolio has a compounded annual return of 10.1 percent while the high-liquidity stock portfolio 0.8 percent.
- For high value stocks, low liquidity stocks have a 17.6 percent return, while high liquidity stocks have a return of 12 percent.
- The liquidity effect was also present in momentum stocks. The highest compound annual return, 14.8 percent, is achieved by buying mid-higher momentum low-liquidity stocks, while the lowest return, 4.6 percent, is for the high-momentum high-liquidity stocks.
Because liquidity-based strategies invest in relatively less liquid -- and typically unglamorous -- stocks, the authors examined whether they might not work well when the market is volatile and has large down-side stresses. They found that:
- The liquidity strategy beats the benchmarks by generating limited downside capture.
- In the U.S. market from 1996 to 2010, liquidity strategies outperform the Russell 3000 Index in 31 out of the 36 months when the stock market was down more than 3 percent.
- During this worst scenario, the Russell 3000 is down 6.5 percent on average, while the liquidity strategy is down only 4 percent.
- When the stock market is up, the liquidity strategy performance is comparable to the market unless the market is up more than 3 percent. The overall downside capture is 56.3 percent, while the upside capture is 83.1 percent.
- Similar results were found in international markets. When the market is down more than 3 percent in a month, the international strategy outperforms the MSCI International Index in 34 out of 37 months. When the market is down less than 3 percent in a month, the strategy outperforms the index 26 out of 32 months. Overall, the downside capture is only 60.5 percent compared with upside capture of 89.8 percent.
This study adds to the literature on the liquidity effect by providing out-of-sample tests in international markets. And it also looked at the performance of the strategy in both bull and bear markets.
Image courtesy of Flickr user Horia Varlan
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