Profiting from harder-to-sell stocks

(MoneyWatch) Whenever stocks have a characteristic that makes them riskier, investors should be compensated for that risk. As it turns out, stocks that are harder to buy or sell without incurring significant market impact costs have indeed rewarded investors for that risk.

The liquidity of an asset refers to the ability of investors to buy and sell significant quantities of the asset quickly, at low cost and without a major price concession. The size of bid-offer spreads (or the difference between the price a buyer is willing to pay and the price a seller is willing to accept) and the amount of daily volume are often used as measures or indicators of liquidity risk. The harder it is to sell an asset, the less liquid it is.

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Because liquidity is a "risk factor," we should expect that liquidity is priced into expected returns. After all, if you received the same expected return for a highly liquid stock and a less liquid stock, you would have no reason to choose the harder-to-sell one. This is confirmed by academic literature, which shows that investors require higher expected returns for stocks with higher bid-ask spreads to offset the higher trading cost. Thus, investing in liquidity as a style has led to excess returns -- there's a liquidity premium.

The authors of the paper "The Liquidity Style of Mutual Funds" examined whether mutual funds can capture this premium. (This premium had previously been documented at the security level.) After adjusting for their exposures to small and value stocks, they found that mutual funds holding less liquid stocks typically outperformed those that held more liquid stocks.

For each of the 16 fund style categories they examined, the funds with the lowest composite liquidity had superior annual geometric (compound) returns, annual arithmetic returns, standard deviations, Sharpe ratios (or risk-adjusted returns) and annualized alphas (excess return) versus both the category's composite average and three Fama-French factors (market risk, size and value). In addition, in most cases the data was statistically significant at the 95 percent confidence level (t-stat of 2 or greater).

For all funds, the annualized return of the funds with the least liquid stocks was 2.7 percent higher than for the funds with the most liquid stocks. Surprisingly, the volatility of these funds was much lower (15.3 percent versus 24.8 percent).

In another surprise, the superior overall performance of the low-liquidity quintiles has primarily come from superior performance in down markets. For example, from September 2008 through February 2009, the least liquid quintile of stocks lost about 40 percent compared to a loss of about 45 percent for the most liquid quintile of stocks.

It appears that liquid stocks are more sensitive to liquidity shocks. This could be because liquidity dries up during crises and trading costs increase, leading investors who need to raise cash to sell their most liquid securities in an attempt to limit trading costs. It could also be because investors (including mutual funds) who own less liquid stocks employ lower-turnover strategies (knowing that their holdings have high turnover costs). Thus, they're less likely to sell during crises.

On the other hand, investors who employ high turnover strategies know they must hold highly liquid stocks to keep trading costs down. The authors confirmed this. They found that the average annual holdings turnover for the mutual funds with the least liquid stocks was about half that of mutual funds with the most liquid stocks (59 percent versus 124 percent).

The authors also examined the data on international funds. The international data is available beginning only in 2000. Their findings were generally consistent with their U.S. findings, though not as statistically significant, partly due to the shorter time frame.

The authors concluded: "The liquidity investment style is clearly present in mutual funds and leads to dramatic differences in performance." The study also demonstrates that the liquidity premium isn't just theoretical. It's captured in fund returns.