(MoneyWatch) It's relatively well known that less-liquid investments tend to outperform more liquid investments. And there's a perfectly logical economic explanation: Since investors prefer greater liquidity all else equal, they demand a risk premium to hold less liquid assets. In other words, they must expect a return premium. This makes liquidity a risk factor, just as beta, size and value are risk factors. And as we have seen, the evidence demonstrates that a liquidity strategy produces risk-adjusted returns that are similar to those of the other three factors, as well as the behavioral-related factor of momentum.
Thomas Idzorek and James Xiong of Morningstar Investment Management and Roger Ibbotson of Zebra Capital Management examined whether this style can be uncovered at the mutual fund level. Covering the period February 1995 - December 2009, they combined Morningstar stock and mutual fund data to build composites of mutual funds based on the weighted average liquidity of the individual stocks held by the funds. They then organized the data around Morningstar categories and their large versus small and growth versus value-style boxes. The following is a summary of their findings:
- In aggregate and across a wide range of mutual fund categories, on average mutual funds that held less liquid stocks significantly outperformed mutual funds that held more liquid stocks.
- The outperformance of the mutual funds that held less liquid stocks was primarily due to superior performance in down markets, especially market crashes.
- For each of the 16 groupings, the lowest liquidity composite had a superior annual geometric return, annual arithmetic return, standard deviation, Sharpe ratio, annualized alpha (or returns above proper benchmarks) versus the category's composite average, and annualized alpha versus the three Fama-French factors (beta, size and value). With the exception of the Growth category, the t-statistic (which measures significance) of the alpha versus the category's composite average of the lowest liquidity composite exceeded 2.0, indicating that the alpha was statistically significant at the 95 percent confidence level.
- In nine of the 16 groupings, the t-statistic of the alpha versus the three Fama-French factors for the lowest liquidity composite exceeded 2.0.
- In 11 of the 16 groupings, the t-statistic of the alpha versus the three Fama-French factors exceeded 2.0.
- For the vast majority of groupings across the five quintiles, the results are monotonic in favor of the lower liquidity composite.
- Using Morningstar's categories, the largest annualized alpha difference between the lowest liquidity and the highest liquidity quintiles occurred within the small category and was 7.1 percent. The smallest annualized alpha difference occurred for the large core category and was 2.7 percent.
- Relative to the Fama-French three-factor model, the largest annualized alpha difference between the lowest liquidity and highest liquidity quintiles was also in small stocks at 4.3 percent. The smallest annualized alpha difference occurred for the large growth category and was still 2.4 percent.
- In all categories, low liquidity outperformed high liquidity in producing superior up market/down market capture ratios.
This paper contributes to the literature by demonstrating that the liquidity premium isn't just a theoretical (on paper) result -- it can be captured by live funds. What it doesn't tell us is whether the mutual fund managers were explicitly focusing on capturing the premium.
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