(MoneyWatch) While liquidity is usually discussed regarding bonds, a recent paper shows that it may have a significant impact on stocks as well.
Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity and small spreads between the bid and offer. Because it's safer to invest in liquid securities than illiquid ones, illiquid assets should have higher expected returns (a risk premium) as compensation for their incremental risks and higher costs of trading. This concept of a liquidity premium is well documented in the academic literature.
However, much of the research has been focused on bonds. Perhaps the most well-known example of a liquidity premium is the fact that what are called "on-the-run" (the most recent issue of a particular maturity) Treasuries trade at lower yields than comparable "off-the-run" (previously issued bonds with the same original term) despite being longer in maturity.
In a normal upward sloping curve, longer bonds should carry higher yields. For example, a 30-year Treasury bond with 29.5 years remaining to maturity will have higher (not lower) yields than a newly issued 30-year bond despite having a shorter remaining term to maturity. Trading this "anomaly" was one of the strategies deployed by Long-Term Capital Management. Unfortunately for the failed hedge fund, it wasn't an anomaly but a risk premium.
The newly issued (on-the-run) Treasury is more liquid. Thus, the higher yield on the off-the-run was compensation for the liquidity risk. This was one of the trades that led to LTCM's demise. They treated this as a free lunch, when it was compensation for risk. The liquidity risk reared its ugly head in the crisis of 1998.
Liquidity also affects corporate bond spreads. For example, when a corporate bond rating falls from investment grade to below investment grade, the liquidity of that bond drops significantly because the charters of many institutional investors prevent them from investing in non-investment grade bonds. The smaller pool of potential investors reduces the liquidity of those bonds. As a result, the yield spread between corporate bonds and Treasuries, and between investment grade bonds and non-investment grade bonds (of the same maturity) is not only compensation for credit risk, but also liquidity risk (Treasuries are the most liquid investments in the world).
Zhiwu Chen, Roger Ibbotson and Wendy Hu, all from Zebra Capital Management, studied the effect of liquidity risk on stock prices. Their measure of liquidity is annual turnover, defined simply as the number of shares traded divided by the stock's outstanding shares. High-turnover stocks tend to have low bid-ask spreads, high trading volume relative to the size of the company, and low price impact per dollar traded. The study covered the top 3,500 U.S. stocks by capitalization and the period 1972 through 2010. They sorted stocks into liquidity quartiles and contrasted them with size or capitalization quartiles. The following is a summary of their findings:
- Liquidity has a substantial impact on the valuation and returns of all types of securities, having a positive long-run impact on returns.
- Liquidity, as measured by stock turnover or trading volume, is an economically significant investment style that is just as strong, but distinct from the other four factors known to explain investment returns (beta, size, value and momentum).
- When converted into a "less liquid verses more liquid" liquidity factor, liquidity is negatively correlated with the market and size factors, but positively associated with value and momentum factors.
- After adjusting for the other four factors, there's still a positive and statistically significant alpha (or additional returns above a benchmark) remaining in almost every case.
- A portfolio investing in less-liquid stocks should be relatively stable over time, so that it can be readily implemented without frequent trading.
They also found that the liquidity premium holds regardless of market capitalization (size). However, the liquidity effect is the strongest among micro-cap stocks and declines from micro- to small- to mid- to large-cap stocks:
- Across the micro-cap quartile, the low-liquidity group earned a geometric average return of 18.2 percent a year in contrast to the high-liquidity group returning 6.2 percent a year.
- Across the large-cap quartile, the low- and high-liquidity groups returned 12.5 percent and 9.9 percent respectively, producing a liquidity effect of 2.6 percent.
- Within the two midsize groups, the liquidity return spread was also significant.
The liquidity premium also holds across growth and value stocks:
- For high-growth stocks, the low-liquidity stock portfolio has a compounded annual return of 11.9 percent, while the high-liquidity stock portfolio returned just 3.9 percent.
- For high-value stocks, low-liquidity stocks returned 20.8 percent return, while high-liquidity stocks returned 12.5 percent.
- The highest return comes from combining high-value with low-liquidity stocks, while the worst return comes from high-growth stocks with high-turnover stocks.
The liquidity premium also held across momentum stocks:
- The highest compound annual return, 17.4 percent, is achieved by buying high-momentum low-liquidity stocks, while the lowest return, 5.6 percent, is for the low-momentum high-liquidity stocks.
The authors also calculated the monthly alphas of the liquidity factor (long low-liquidity stocks and short high-liquidity stocks) and found the following:
- Using the Fama-French three-factor model (beta, size and value), the monthly alpha was 0.50 percent. And the t-stat was 3.6 (highly significant).
- Using the four-factor model (adding momentum), the monthly alpha was 0.34 percent with a t-stat of 2.5 (also significant).
From a long-only perspective (the way most mutual funds invest), the monthly premiums were a still substantial 0.20 percent using the three-factor model (t-stat 4.1), and 0.16 percent (t-stat 3.3) using the four-factor model.
The authors explain that the source of the higher returns comes not only from compensation for taking liquidity risk, but also from stocks "migrating" between liquid and less liquid (just as stocks migrate from small to large and value to growth, and vice versa). For example, they found that in the lowest liquidity quartile, only 74.9 percent remain a year later, with 25.1 percent moving to higher liquidity quartiles.
As stocks migrate to higher liquidity quartiles, they earn dramatically higher returns, and vice versa. For example, 70.9 percent of stocks remain in the most liquid quartile during the next year. As the remaining 29.1 percent drop into lower quartiles, they actually earn negative returns (as investors demand higher risk premiums as compensation for the greater liquidity risk). Less liquid stocks migrate toward more liquid quartiles while more liquid stocks migrate toward less liquid quartiles.
The authors found that the migration of liquidity is the primary driver of returns. They also saw no reason to believe that either of the two sources of extra return for illiquid stocks should be expected to disappear: "Liquidity will continue to be valued high, and illiquid stocks will still come at a discount." Thus, liquidity as an investment style is likely to continue to outperform.
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