Smart Money
July 23, 2014 9:11 am
Long-term returns boosted by illiquidity
The less liquid a stock, the better it will perform over time
And then there were four. Followers of the dialogue between financial academics and investors will know there is agreement on three factors that cause stocks to outperform the market in the long term.
They are size (small stocks beat large one in the long run); value (cheaper stocks beat expensive ones); and momentum (winners tend to keep winning while laggards tend to keep lagging behind).
Now it appears there is a fourth: liquidity. The less liquid a stock is, the better it will perform in the long run, compared with more liquid stocks.
The financial academic community has given this notion its imprimatur. This week, the Graham & Dodd prize (named for the academics who founded value investing) for the best 2013 article in the Financial Analysts Journal went to Yale’s Roger Ibbotson, one of the best-known finance researchers, for what may become a seminal article laying out why liquidity should join size, value and momentum.
Readers of a practical bent should not switch off - for decades, breakthroughs in academic finance have driven financial innovation in the real world, both for good and bad. Huge sums of money are managed based on the three factors already acknowledged. For good or ill, Mr Ibbotson’s article is likely to spur a boom in investing in illiquid stocks. So it is vital to understand his insight, and how it might be put into practice.
Lower turnover
That sounds as though low-liquidity investing might just be value investing in a different guise. But Mr Ibbotson and his colleagues performed the same exercise of ranking and producing quartiles for all the other recognised styles. This found the liquidity style is indeed positively related to value. They do have overlaps. But the researchers examined the performance of illiquid stocks that could be explained by stocks’ cheapness – and found there was still significant outperformance by illiquid stocks that could not be explained that way, and which remained statistically significant.
Overall, it found the difference between high- and low-liquidity stocks was similar to the difference between highest and lowest stocks when ranked by the other styles. Low-liquidity stocks tend to stay illiquid, meaning there is no need to keep trading in and out of stocks over time. And over the full 1972-2011 period, illiquid stocks fared better than small stocks and high-momentum stocks.
Higher transaction costs
Why should this be so? The most logical answer would have to do with risk. We need to be compensated to take extra risk.
Daniel Kim, one of the co-authors and research director for Zebra Capital Management in Connecticut, reports that illiquid stocks suffered far lower drawdowns during the most dramatic days of heavy selling. That was because, in an emergency, people sold whatever they could, so liquid stocks were sold first.
Over the four decades of the research, liquidity was inversely related to risk – the lower the liquidity, the higher the return and the lower the risk. Its performance is asymmetrical; it tends to underperform slightly on the way up, but strongly outperform during sell-offs.
Why should illiquid stocks return a premium? It is clear from other asset classes that extreme illiquidity carries a premium.
Yale University’s endowment under David Swensen has spent many years harvesting exactly this premium by investing in highly illiquid assets such as forestry. So something similar might be at work within the public equity market.
Do the extra transaction costs negate all the benefits? That problem is most easily solved by holding stocks for a long time, and waiting for the proportionate weight of the transaction costs slowly to reduce.
Will the illiquid stock anomaly persist now that it has been spotted and people are beginning to try to take advantage of it? Quite possibly not. But a lot of money will need to move into illiquid stocks before the anomaly is eliminated.
They are size (small stocks beat large one in the long run); value (cheaper stocks beat expensive ones); and momentum (winners tend to keep winning while laggards tend to keep lagging behind).
Now it appears there is a fourth: liquidity. The less liquid a stock is, the better it will perform in the long run, compared with more liquid stocks.
The financial academic community has given this notion its imprimatur. This week, the Graham & Dodd prize (named for the academics who founded value investing) for the best 2013 article in the Financial Analysts Journal went to Yale’s Roger Ibbotson, one of the best-known finance researchers, for what may become a seminal article laying out why liquidity should join size, value and momentum.
Readers of a practical bent should not switch off - for decades, breakthroughs in academic finance have driven financial innovation in the real world, both for good and bad. Huge sums of money are managed based on the three factors already acknowledged. For good or ill, Mr Ibbotson’s article is likely to spur a boom in investing in illiquid stocks. So it is vital to understand his insight, and how it might be put into practice.
Lower turnover
Liquidity can be measured in many ways. The measure Mr Ibbotson and his colleagues chose was turnover – the proportion of a stock’s market capitalisation that changed hands on any given day.
They then ranked 3,500 US stocks by their turnover and ranked them into four quartiles. This showed that the least liquid quartile, from 1972 to 2011, returned an average of 16.38 per cent, compared to 11.04 per cent for the most heavily traded stocks, and 14.46 per cent for the universe of stocks under control.
They then ranked 3,500 US stocks by their turnover and ranked them into four quartiles. This showed that the least liquid quartile, from 1972 to 2011, returned an average of 16.38 per cent, compared to 11.04 per cent for the most heavily traded stocks, and 14.46 per cent for the universe of stocks under control.
How much does this mean? In practice, this means that liquidity tends to overlap with “newsworthiness” or “popularity”. Stocks at the centre of attention like Google or Facebook are highly unlikely to show up as low-turnover stocks for many years to come. Stocks that are neglected and ignored will be relatively illiquid.
Overall, it found the difference between high- and low-liquidity stocks was similar to the difference between highest and lowest stocks when ranked by the other styles. Low-liquidity stocks tend to stay illiquid, meaning there is no need to keep trading in and out of stocks over time. And over the full 1972-2011 period, illiquid stocks fared better than small stocks and high-momentum stocks.
Higher transaction costs
Why should this be so? The most logical answer would have to do with risk. We need to be compensated to take extra risk.
As illiquid stocks should be harder and more expensive to trade, it becomes harder for share prices to readjust smoothly, creating volatility. But in practice, the experience of the 2008 crisis was exactly the opposite.
Over the four decades of the research, liquidity was inversely related to risk – the lower the liquidity, the higher the return and the lower the risk. Its performance is asymmetrical; it tends to underperform slightly on the way up, but strongly outperform during sell-offs.
Why should illiquid stocks return a premium? It is clear from other asset classes that extreme illiquidity carries a premium.
Yale University’s endowment under David Swensen has spent many years harvesting exactly this premium by investing in highly illiquid assets such as forestry. So something similar might be at work within the public equity market.
Do the extra transaction costs negate all the benefits? That problem is most easily solved by holding stocks for a long time, and waiting for the proportionate weight of the transaction costs slowly to reduce.
Will the illiquid stock anomaly persist now that it has been spotted and people are beginning to try to take advantage of it? Quite possibly not. But a lot of money will need to move into illiquid stocks before the anomaly is eliminated.
Copyright The Financial Times Limited 2014.
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