Liquidity: A hidden gem of factor investing?
31 May 2018 | Topical insights
Interest in factor-based investing is on the rise. Vanguard's head of Quantitative Equity Product Management, Matt Jiannino, and senior product manager, Frank Chism, have been fielding questions on leveraging factor exposures – especially liquidity.
What they've discovered is that while some investors and advisers are intrigued by liquidity, others are hesitant to adopt it as a strategy. Naturally, many want to perform due diligence before investing in these products.
What has the reception to liquidity as a factor been like?Matt Jiannino: Advisers have read a lot about value and momentum in the press. But while the liquidity factor is just as enduring, it's kind of a hidden gem that people aren't aware of. It's existed just as long and makes intuitive sense when you realise that you're getting it in other spaces. And every time we talk to advisers about this, they get it.
Frank Chism: And when they get it, they're into it. They see it as something different, which makes it useful. I recently met with an adviser who showed me his portfolio, and it had a little bit of everything. But it didn't have liquidity represented. He wanted to figure out how to get it in there. So it's something people are hungry for even though they haven't had access to it before.
Where does the liquidity conversation usually start?
Frank Chism: I tell them our story. When Vanguard was considering launching factor products, we went to our Quantitative Equity Group (QEG), who have been running a multifactor product since the early '90s, and asked which single-factor products we should offer.
The first three [that people] came back with were quality, value and momentum. We thought that was great because they're [basing their outlook on] Fama-French's research and other academic studies, so we were very familiar with those. Then QEG said liquidity. My first reaction was, "Where's size? Size is the other Fama-French factor, why aren't we doing that?"
Matt Jiannino: What we found out was that in many cases, active managers' small-cap strategies were really attempts to access this liquidity premium that exists out there.
Frank Chism: Right, so we think liquidity is a distinct factor. And a third of Vanguard's single-factor portfolios are in small caps, so we're getting size exposure anyway.
So what premium is Vanguard targeting?
Matt Jiannino: The premium is that relatively less liquid securities tend to outperform their more liquid peers. If you look across the entire market-cap spectrum, you see this premium. Even if you look at large-cap, if you were to divide the world of large-cap stocks and order them from more liquid to less liquid, the less liquid part has outperformed.
Considering its ties to size, is it safe to say investors have been getting liquidity exposure without realising it?
Frank Chism: Yes, they've been getting it as a by-product. If [for example] you equal-weight the Russell 2000 Index, you're going to own as much of the smallest [equity] names as you do of the biggest ones. And some of the ones at the bottom will be remarkably less liquid than the biggest ones. So you're getting it, but we would say, 'Why would you own the super-liquid ones? Why not just go after the less liquid ones?'
Matt Jiannino: And some of those larger names could be less liquid. If they are, you would target them. But you want to be explicit in what you're targeting. The liquidity factor targets the premium that investors such as endowments and foundations are trying to get by buying real estate, private equity, fixed assets and things like that that most investors can't access.
Why is that?
Matt Jiannino: They either can't get access to private equity or can't find a way to make money doing so. Or they don't have the capital to buy a diversified portfolio of real estate.
Frank Chism: Think of it this way: Someone might buy one rental house to add income to their portfolio, but they’re not able to effectively build a real estate portfolio.
Matt Jiannino: But if you were able to diversify across multiple real estate assets, not only do they add that income, but a lot of what you’d also capture is this liquidity premium. You've diversified away the single-property risk, and now you hold a portfolio of properties. And what you're capturing is the premium that exists for holding that diversified portfolio of illiquid assets. It may take you a long time to sell a single property, but with a liquidity factor fund, you could find a different property to sell.
With the liquidity product, you can build a diversified portfolio across liquid assets, and hold less liquid names to collect the premium. To get the premium, you have to build diversified portfolios. Holding a single name gets you exposure, but it comes along with all the idiosyncratic risk of holding a single asset. A good way to look at it is like having a huge art or antique-car collection. Buying one classic car or painting is probably not a good investment. You probably want a diversified portfolio so that you're not relying on one piece.
Frank Chism: And there's a tremendous amount of costs with collectibles, and also private equity. If you have to hire someone to buy private companies, they have to be compensated.
So the fund helps you get the instant access to the liquidity premium, but it's at an obtainable price. There's no middle person. We can do it quantitatively, and very quickly, across the whole market.
What should an adviser's goal be?
Matt Jiannino: Primarily these products are for those who believe that the value factor exists and that it's enduring. They want to add the tilt to their clients' portfolios to realise that premium long term.
Frank Chism: I totally agree. One of the objectives is to outperform the market. In the same way investors put exposure to value in their portfolios because they believe it will outperform over long periods of time. You'd say the same thing about liquidity.
How does the way we target liquidity work?
Frank Chism: When you think about factor investing, you're really trying to create exposure or have beta to the factor. If the factor does well, you want your portfolio to mirror that performance.
So you must decide on the characteristics of equities that are going to make your portfolio move in line with that factor. For liquidity, we look at each stock and say:
- How much turnover has it experienced on an average daily basis over the last year in terms of percentage of shares outstanding that are trading?
- How much, in terms of pounds or dollars, is trading on an average daily basis? We do that to scale things. You might have a company that trades a lot of shares outstanding, but it might be a really tiny company that's really only trading a few thousand pounds a day. Or you might have a giant company that's not trading too many of its shares, but it's expensive enough to make it look as if it has huge trading volume.
- What's its Amihud illiquidity score? Yakov Amihud came up with a way for measuring liquidity in a stock market: You take the amount of a price change a stock is experiencing on average on a daily basis and divide it by the dollar turnover measure. And you're looking for a big number, meaning if a stock is experiencing a lot of price movement, you want the amount of trading to not be that big.
So we're looking for stocks that don't have to trade a whole lot to move the price. Stocks where you can trade a great many shares and the price barely moves are what we shy away from.
You take an equal-weighted ranking of the three factor scores, and you go through each of the segments of the market and rank them separately. We construct the portfolio by taking the best stocks on those three measures from each of the three market-cap buckets.
Is there a liquidity "sweet spot" that we aim for?
Matt Jiannino: We're not targeting a number. It's all about taking the companies that score best on these liquidity measures relative to their peers.
That's why we built it the way we did. Some people say, "900 stocks, wow that's a lot." Nine hundred companies gets us a ton of targeted exposure to a factor in a diversified portfolio so that one name shouldn't affect the overall return of the portfolio. The return of the factor is what's captured long term.
How do you get a liquidity premium if you're buying the things that are less liquid? Are you potentially buying away the premium at some point?
Frank Chism: We get this question a lot. If someone gives us a few million dollars to add to a portfolio, we're not adding a tremendous amount of money to any single name. Plus, the names need to have at least US $2 million [about £1.5 million] worth of average daily volume to pass the initial liquidity screening.
You'd have to see numbers like $40 million, $50 million, $80 million [about £30 million, £37 million, £60 million, respectively] in a day to get to a point where you're talking about being a significant chunk of the daily trading value. And even then, we're active, so we could spread it out or do something to counter that. We'd have to get to tens of billions of dollars, north of $20 billion [about £14.9 billion] at least, before we even start to look at whether we're getting less of a liquidity premium.
Matt Jiannino: I think about the lottery effect, where investors search for the one stock that goes up 200%. Those companies are out there, and people continue to hunt for those. But for every one of those, there's a bunch more that blow up or don't do anything.
What we're talking about with long-term factor strategies is not finding a single company, but capturing factors that exist out there. If all these funds had a motto, it would be that they're a convenient, low-cost, targeted exposure to an enduring premium that's difficult to access anywhere else.
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