Liquidity is valuable to investors. Therefore, investors demand higher expected returns for less liquid stocks. The liquidity of an asset market refers to the ability of investors to buy and sell significant quantities of that asset, quickly, at low cost and without a major price concession.
Thus, liquidity risk can be thought of as the risk to investors that an investment cannot be bought or sold quickly enough to prevent or minimize a loss. The size of the bid/offer spread and the amount of daily volume are frequently used as measures, or indicators, of liquidity risk.
An important question is whether investors demand higher returns from less liquid securities. The academic literature includes a number of studies showing that liquidity risk is indeed priced into expected returns. In other words, investors do require higher expected returns for stocks with greater bid/ask spreads to offset higher trading costs.
The Truth About Liquidity
For example, the authors of a 2010 study, “Liquidity as an Investment Style,” found that liquidity, as measured by stock turnover or trading volume, is an economically significant investment that remains distinct from traditional investment styles such as size, value/growth and momentum.
The literature also shows that sell-order illiquidity is priced more strongly in the cross section of expected equity returns than is buy-order illiquidity. In fact, the liquidity premium in stocks emanates predominantly from the sell-order side. This was the finding of the authors of a 2012 study, “Sell-Order Illiquidity and the Cross-Section of Expected Stock Returns.”
The literature provides us with yet another risk-based insight on the liquidity premium. The authors of a 2010 study, “Pricing Liquidity Risk and Cost in the Stock Market: How Different Was the Financial Crisis?”, concluded that markets require a higher premium for liquidity sacrifice in negative environments. Investors who hold illiquid stocks and become liquidity takers (through divesting them, either to meet liquidity needs or due to panicked selling) pay a steep price to do so.
They also found that unexpected illiquidity costs always have a larger influence on excess returns than expected illiquidity costs, in cases of both boom and crisis. Their explanation was that investors react more forcibly to the unknown liquidity shocks than to the predictable illiquidity costs. Thus, an additional premium is required for the cost embedded in the unexpected part of illiquidity.
The International Evidence
Yakov Amihud, Allaudeen Hameed, Wenjin Kang and Huiping Zhang, authors of the study“The Illiquidity Premium: International Evidence,” which appeared in the August 2015 issue of the Journal of Financial Economics, contribute to the body of literature by examining the illiquidity premium—which the paper defines as the excess return on high-illiquidity stocks minus low-illiquidity stocks across volatility-based portfolios, or IML (the return on illiquid stocks minus the return on liquid stocks)—in stock markets in 26 developed-market countries and 19 emerging market countries. The data covers the 21-year period from 1990 through 2011.
Following is a summary of the authors’ findings, all of which are intuitive from a risk perspective:
- As theory predicts, the illiquidity premium is positive and highly significant worldwide after controlling for global and regional common risk factors.
- The average monthly IML is 0.77% for an equal return-weighted portfolio and 0.46% for a value-weighted portfolio. When adjusting for free-float, the IML was virtually unchanged.
- IML is much higher (about twice as large) for emerging markets than it is for developed ones.
- Median returns are very close to the mean returns, suggesting that the results are not generated by extreme cases (very thinly traded stocks).
- The country-level illiquidity premium varies considerably over time. IML is higher when global market returns are lower, meaning liquidity is more valuable in bad times.
- Global IML is significantly affected by credit conditions, measured by the U.S. yield spread between commercial papers and Treasury bills. The value of liquidity is positively affected by a rise in the credit spread, and is negatively affected by a decline in market prices. In other words, the illiquidity premium is higher during adverse market conditions. When market prices fall, traders need more funding to finance their positions, which become credit-constrained (for instance, due to margin calls). This forces them to liquidate their assets, which in turn makes liquidity more valuable.
- Country-illiquidity premiums are lower in nations with better disclosure of corporate information and better governance rules and procedures. Better disclosure reduces information asymmetry between investors and corporate insiders, and should thus improve liquidity and reduce the illiquidity premium.
- Firm size is associated with liquidity, suggesting that the size premium is due partly to the illiquidity premium. Size is a partial proxy for liquidity. On the other hand, there is no clear relation between the illiquidity premium and the value premium.
- A country’s IML covaries positively with the global average IML after controlling for global and regional common risk factors. This reduces the ability to diversify against liquidity shocks.
Another Side To A Global Risk
Summarizing, liquidity is a priced risk around the globe. It’s also a risk that tends to correlate highly with equity risk, showing up at the worst of times (such as when labor capital becomes riskier). It’s also a partial proxy for the size premium, although not the value premium. That said, as is the case with most risk stories, there’s another side to this one as well.
Investors who are able to act as liquidity providers during periods when liquidity is stressed can benefit by earning a larger liquidity premium. For example, a small-cap or emerging market mutual fund that must sell stocks to meet redemption demand will pay a steep price to trade in bad times. Patient buyers on the other side of the trade earn larger liquidity premiums during such periods. Warren Buffett is probably the most-well-known patient buyer. However, there are mutual funds that can also act, at least to some degree, as patient buyers.
A good example is Dimensional Fund Advisors (DFA), which, to my knowledge, was the only mutual fund family to receive net cash inflows into its equity funds during the recent financial crisis. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) Investors in their funds tended to rebalance into stocks instead of engaging in panicked selling. Not being concerned with replicating the returns of a benchmark index allows them to trade more patiently.
There are two important takeaways from the evidence on liquidity risk. First, liquidity risk should be a consideration when you design a plan, both in terms of your asset allocation and your choice of investment vehicles. Second, the fact that IML is a premium for taking risk that shows up in bad times has implications for the type of bonds used to implement the fixed-income portion of your portfolio.
The evidence presented highlights the importance of owning assets that perform well during bad times, when liquidity risks rears its ugly head. Thus, you should strongly consider owning only safe, liquid bonds. U.S. Treasurys are the safest and most liquid of bonds. As such, their diversification benefits tend to show up most strongly when they’re needed most. While their correlation with U.S. stocks is about zero over the long term, during bear markets, the correlation turns highly negative.
Other safe fixed-income investments you should consider are FDIC-insured CDs and municipal bonds that are rated AAA/AA and are also either general obligation bonds or essential service revenue bonds.
This commentary originally appeared December 4 on ETF.com
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