Drawing systematic value from the equity liquidity premium
04 August 2017 | Portfolio construction
Commentary by Matthew Jiannino of Vanguard Portfolio Review Department, Daniel D. Reyes of Vanguard Investment Strategy Group, and Fei Xu of Vanguard Quantitative Equity Group.
Some investments are more liquid than others, and that superior liquidity comes at a price.
Simply described, liquidity is the degree to which an asset can be quickly bought or sold in the market without affecting its price. Like other well-known stock-level characteristics such as value, it exists across every area of the equity market. If we recognise that liquidity has a price, can it be reduced to a systematic investment factor?
It was Nobel laureate William Sharpe who originally identified investment factors. He stipulated that a factor has four characteristics: it needs to be identifiable "before the fact", not easily beaten, a viable alternative and low cost. The most widely accepted factors are value, size and momentum. Increasingly, liquidity is recognised as another pillar.
The liquidity spectrum
Liquidity exists on a spectrum, rather than as a binary characteristic that an asset either has or does not have. At one end of the spectrum are assets such as infrastructure and large-scale commercial property, in which a transfer of ownership can take years of complex negotiation. Coming down the spectrum will be assets like works of art and antiquities, private equity investments and venture capital, until we get to the other end, where would expect to find highly liquid assets such as publicly listed equities, short to mid-maturity US Treasuries and major interest rate and currency futures contracts. These latter types of assets can typically be sold in moments, at any time of the day or night, through a multiplicity of platforms and at widely accepted, published prices.
We intuitively understand that relative liquidity has value when we think in these fairly broad terms – the liquidity difference between a building and an ordinary share in a FTSE 100 company. But liquidity differences can be narrowed to finer and finer gradations and also exist within the public equity markets. An example might be the common stock of two similar companies, say two oil majors or two global banks. Bank products are notoriously fungible, but there are still very many attributes that can affect the relative liquidity of shares in two banks: management, debt levels, political and ethical issues, to name a few.
Why liquidity carries a premium
Academic research points to two primary reasons why investors should be compensated with higher expected returns for holding stocks with relatively less liquidity. One school of thought contends that liquidity is a characteristic of a stock's trading, and that the expected return premium is less related to risk than to the higher cost and difficulty of transactions. Investors who bear this additional trading difficulty should reasonably expect a return premium to make up for that additional cost.
A second school of thought argues that it is not only stock-level characteristics that influence the relative liquidity of particular instruments. Whole-market and temporal conditions also play a part and individual stocks have different sensitivities to these changing conditions. On this view, a stock's sensitivity to whole-market liquidity conditions, or "liquidity beta", drives the return premium.
Liquidity vs. size
One of the common critiques we hear about liquidity as a style factor is that it overlaps with other well-known factors, size in particular. Our research shows that it is relative level of liquidity that determines the liquidity premium, regardless of capitalisation. This suggests that relative illiquidity can be systematically captured, in the same way that value can be captured, along the entire breadth of market capitalisation. We have tested this extensively using the Russell universe of United States equities – the Russell 1000, the thousand largest US stocks, and the Russell 2000, the next 2,000 stocks down the capitalisation scale.
This is a large, actively traded universe, and we believe the results extrapolate to global equities and other large, liquid markets more generally. Our sample data consisted of the years 1991–2016, a period that saw several market cycles, including the technology bubble and the global financial crisis.
Our starting point was to synthesise into a composite three different, though related, measures of liquidity. The first was turnover, for which we took annual average daily turnover (shares traded as a percentage of shares outstanding). The second was volume, for which we took the annual average daily volume (dollar value). The third was what is known as the Amihud measure (Amihud ,2002), which gauges price impact for a given trading volume1.
We averaged these three measures together to create a composite. We used this composite to sort the universe of stocks. We then separated the sorted list of stocks into three equal-sized groups that contain the least liquid one-third, the middle third and the most liquid one-third. We did this sorting and separation within three separate universes, or "layers", defined by market capitalisation: The Russell 2000, the next largest 800 stocks, and then the Russell 2000 (R2K).
For each layer, we subtracted the equal-weighted average annual return of the most liquid one-third of stocks (T1 in the chart below) from that of the least liquid (T3). We took this as a fair measure of the liquidity premium at each level on the capitalisation scale. At each capitalisation layer, there were return differences in the returns generated by distinct liquidity groups. The relatively more liquid one-third of the largest capitalisation stocks were seen to generate an annual average premium of 2.4%. The less liquid group in the middle layer, made up of next largest 800 stocks, generated a premium of 2% and the lowest layer, the R2K, generated a premium of 5%.
Composite liquidity matrix
The data suggest that a liquidity premium exists across the size spectrum:
Source: Vanguard, Russell data 1991–2016. Figures are subject to rounding.
We have run further analyses to test these results. These have included comparing our composite results with returns ordered purely on the basis of size. This showed a quite different set of outcomes, further suggesting that the liquidity and size premiums are quite separate factors.
Liquidity vs. value
A second common critique we hear about liquidity as a factor is that it is equivalent with value. A quite different angle in our research was to divide stocks by their book-to-price, or value factor, and then to look at their composite illiquidity. While there is some overlap between the liquidity and value factors, the liquidity element remained significant and, in pattern and magnitude, in line with our original composite. Large-cap value stocks showed a liquidity premium of 1.9% over the period, while smaller-cap value stocks showed a premium of 3.5%
Liquidity and value
A meaningful liquidity premium is evident among value stocks
Source: Vanguard, Russell data 1991–2016. Figures are subject to rounding.
We should bear in mind that these historical premiums do not take account of implementation costs. But for investors able to cope with the cyclicality associated with any active strategy, a fund that systematically captures the premium generated by the liquidity factor may offer investors the opportunity to tilt their portfolios in a manner that is at once controlled and meaningful. It can significantly reduce costs, as investors pay only for the returns they want, while offering a powerful addition to a well-balanced, focused investment portfolio.
1 Amihud, Yakov, 2002, "Illiquidity and stock returns: Cross-section and time series effects", Journal of Financial Markets 5, 31-56.
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