A number of academic studies suggest that illiquid stocks should outperform liquid stocks to compensate for higher risk. Yet evidence supporting the existence of a persistent Liquidity effect for equities is weak. As a result, we don’t include Liquidity in our set of relevant factors for quantitative equity strategies.
Liquidity can be defined as the ease of executing a transaction without creating excessive costs. When executing a transaction, investors pay explicitly for the prevailing bid-ask spread, and implicitly for any adverse price swings due to the removal of liquidity from the market. All else being equal, the more illiquid a stock, the more difficult and expensive it is to trade it, and this property makes illiquid stocks less attractive than liquid stocks.
For this reason, illiquid stocks should command a premium to be held, or conversely, liquid stocks should trade at a discount. This reasoning warrants the existence of a liquidity factor premium in stock returns, and some academic studies indeed claim to observe such a premium in the data. However, unlike other established factors, liquidity has never received much attention from institutional investors, at least not in equity markets.
One possible reason for this is that investment strategies based on the liquidity factor are difficult to implement in practice. While other established factors can be exploited in broad, diversified portfolios that are considered investable from an institutional investor’s standpoint, these investors often face liquidity constraints in their allocation decisions, that make an equity strategy that explicitly invests in illiquid stocks less appealing.
Another possible explanation is that the evidence for the existence of a liquidity premium is not very solid. While liquidity undoubtedly matters when it comes to portfolio construction and implementation, it is not clear whether stocks earn higher returns simply because they are illiquid. In other words: are equity investors compensated for taking on extra illiquidity risk?
Over the past few decades, a number of academic studies1 have presented evidence in favor of existence of a relationship between liquidity and stock returns. However, the robustness of these findings has been called into question. In particular, multiple studies2 have shown that the liquidity effect is not robust across different time periods, and can only be found during the in-sample period, if at all.
Moreover, the liquidity effect is largely driven by microcaps, which represent around 3% of total market cap of the US stock market, but account for around 60% of the total number of stocks Once these elements are taken into account, the evidence vetting the existence of a well-rewarded liquidity factor simply cannot be found.
But while the existence of a stand-alone liquidity factor is questionable, interactions between liquidity and other established factors do exist. The relationship between size and liquidity is a good example of this, as small stocks also tend to be less liquid. More generally, it makes sense that some factors are stronger amongst illiquid stocks, since illiquid segments of the market are less efficient at determining the fair value of assets.
Small, illiquid stocks can therefore be seen as a catalyst for other factor premiums, as opposed to an independent source of return. Provided there are interaction effects between established factors and stock-level liquidity, it is the job of an active manager to identify and model these effects in the stock selection and portfolio construction phases. Given that these stocks, by definition, tend to be more difficult and expensive to trade, smart portfolio implementation can therefore add substantial value for investors.
Liquidity is a critical element to take into account when translating theoretical investment strategies to live portfolios. In the words of André Perold from Harvard Business School, “There are crucial differences between transacting on paper and transacting in real markets”. This gap is better known as the ‘implementation shortfall’. When constructing investment portfolios, trading costs, which are a direct function of the liquidity level of a stock, erode the expected alpha.
Although expected alphas are driven by exposures to proven factor premiums and liquidity does not qualify as an independent alpha factor, it is nonetheless a key driver of transaction costs, and therefore net returns. As a result, a sophisticated portfolio construction process and smart portfolio implementation can add a lot of value to the investment process.
1See for example: Y. Amihud and H. Mendelson, ‘Asset pricing and the bid-ask spread’, Journal of Financial Economics, December 1986; V. Datara, Y. Naikb and R. Radcliffec, ‘Liquidity and stock returns: An alternative test’, Journal of Financial Markets, August 1998; T. Chordia, A. Subrahmanyam and V. Anshuman, ‘Trading activity and expected stock returns’, Journal of Financial Economics, January 2001; V. Acharya and L. Pedersen, ‘Asset pricing with liquidity risk’, Journal of Financial Economics, August 2005, L. Pastor and R. Stambaugh, Liquidity Risk and Expected Stock Returns, Journal of Political Economy, June 2003.
2See for example: J. Drienko, T. Smith and A. von Reibnitz, ‘A Review of the Return–Illiquidity Relationship’, Critical Finance Review, Forthcoming October 2018; K. Hou, C. Xue, and L. Zhang, ‘Replicating Anomalies’, NBER Working Paper, 2017; H. Li, R. Novy-Marx and M. Velikov, ‘Liquidity risk and asset pricing’, 2017.