risk and reward

Liquidity: Is It a Risk Factor?

risk and reward

According to Investopedia, liquidity is defined as the degree to which an asset can be bought or sold in the market without affecting the asset’s price. If you have ever attempted to sell a large block of a thinly traded stock, then you know what liquidity (or rather illiquidity) is. Many prominent members of the academic investment community have argued that investors in illiquid securities can expect an additional return (a risk premium) for bearing that particular risk. Yale’s Chief Investment Officer, David Swensen, wrote in his 2000 book, Pioneering Portfolio Management, “Accepting illiquidity pays outsize dividends to the patient long-term investor.” Another Yalie (i.e., a Yale professor) and one of our heroes at Index Fund Advisors, Roger Ibbotson, published a paper1 with three other researchers in which they argued that liquidity is as much of a risk factor as size, value, and momentum. Furthermore, it deserves equal consideration when designing or trading a portfolio.

Interestingly, Roger Ibbotson (who is actually one of Eugene Fama’s earliest students) serves as a director and trustee of Dimensional Fund Advisors (DFA), yet DFA has never proclaimed liquidity as a risk factor that they incorporate into their funds. However, DFA strives to be a provider of liquidity (for which its shareholders get paid) rather than a seeker of liquidity in the financial markets. Since illiquidity entails a high trading cost, it may be given consideration along the same lines as momentum. Specifically, it can dictate when not to trade a security rather than when to trade it, but if there is another participant in the market who is motivated to buy or sell a large block of an illiquid security, then that party can be made to pay the entire cost of the trade.

It is our opinion that the best way for investors to capture the liquidity premium is not by attempting to buy and sell individual illiquid stocks, as that can be a dangerous game. Instead, they should own them through index funds that are tilted towards small cap stocks, where the lower liquidity stocks tend to reside. DFA recently completed a white paper2 that validates our opinion. This statement best summarizes their findings: “Our results indicate that the relationship between liquidity and returns is not robust through time and is mostly isolated to small portions of the market.” When Fama and French were asked about liquidity as a compensated risk factor on the Fama/French Forum, they pretty much dismissed it out of hand:

"There are academic papers that address this question. Some papers say that the differential exposures of stocks to a liquidity risk factor account for differences in average returns. We are far from convinced. The problem is that exposures to this risk factor are estimated quite imprecisely. They look like statistical (random) noise, and noise can't be the source of real differences in expected returns. (You can't explain something with nothing.) From a more practical perspective, if estimated exposures to a risk factor are just statistical noise, they cannot be used to improve investment decisions."

One of the key problems in researching liquidity is settling upon a metric. Although an individual investor may measure the liquidity of an individual stock at a given time by its bid/ask spread and the structure of its order book (i.e., the number of shares either demanded or available at each price), this measure simply is not feasible for a long-term study of the entire market. Unfortunately, there is no universally agreed upon measure of liquidity for research purposes.  The DFA paper analyzed three widely accepted yet different liquidity measures. The time period studied was the 50.5 year period ending 12/31/2012.  For one of the three measures of liquidity, it was only found to be both an economically and a statistically significant factor (t-statistic greater than 2) only among microcaps (approximately the smallest 5% of investable stocks). When the period analyzed was shortened to 22 years, the results were no longer statistically significant. The fact that the significance was confined to microcaps implies that the liquidity premium would be very difficult (if not impossible) to capture via active trading. While liquidity may indeed be a compensated risk factor, it may only be available to the patient long-term investor identified by David Swensen who is willing to own small companies that few people have ever heard of (but not penny stocks!).

For many novice investors, liquidity is one of those things that is everywhere when they don’t need it and nowhere when they do. Investors in Dimensional funds have benefitted from their patient and flexible trading processes that have results in transactions at favorable prices. To learn more about Dimensional funds and the benefits of working with a fiduciary wealth advisor, please call us at 888-643-3133.

 

1Ibbotson, Roger, Zhiwu Chen, Daniel Y.-J. Kim, and Wendy Y. Hu. 2013. “Liquidity as an Investment Style.” Financial Analysts Journal, Vol. 69, No. 3 (May/June).

2Davis, James L., Wes Crill, and Marlena Lee. 2014. “Liquidity and the Cross Section of Expected Returns.” Dimensional Research, January.