Liquidity is a very important aspect when considering any investment. It is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity or "marketability" is characterized by a high level of trading activity. Assets that can by easily bought or sold, are known as liquid assets. It is the ability to convert an asset to cash fast.
It is safer to invest in liquid assets than illiquid ones because it is easier for an investor to get his/her money out of the investment. Examples of liquid assets are publicly traded financial instruments like blue-chip stocks and several mutual funds.
The fact is that all things being equal, the liquid investment ought to have a greater appeal than an illiquid one. The ony problem is that liquidity, some times, is weighed far too favourably as a feature of an investment vehicle - and investors may overlook how attractive the investment actually is, intrinsically.
Liquidity is of greater value to frequent traders, who stand to lose what is known as the "spread" i.e. the inherent difference between purchase and sale prices. The greater investment the liquidity, the lower will be the spread.
For example, a rare artifact or an island home that you may want for your collection would require a high purchase price (because there few substitutes), but in turn, it could be difficult to sell at an equally high price if the aren't enough buyers who value this exotic investment similarly.
For long-term value investors like Warren Buffett as well as retail investors who focus on compounding growth rather than trading profits, this is not so much of a concern - as long as the investment CAN be sold eventually without an undue loss due to severe illiquidity or poor demand in the market.
On the contrary, a good investment bought when it is unpopular or not actively traded usually would become more and more liquid as the market realizes its folly in pricing it, and its demand increases with time.
To summarize: Liquidity alone is never a good measure of investment value. Do not ignore or select an investment only because it is illiquid. On the contrary, it is better to buy a good investment that is liquid (both at the time of purchase and sale), as long as it is priced fairly.
Article in The Business Times (Singapore)
Executive Money Section
Published September 15, 2010
Less liquid stocks give higher returns
A liquidity approach to picking stocks trumps other investment styles
By GENEVIEVE CUA
PERSONAL FINANCE EDITOR
YOU'VE heard of value, growth and momentum as investment styles; and picking stocks based on market capitalisation. But what about liquidity? Roger Ibbotson, finance professor at Yale who is well-known for his research on long-run stock returns, has published research that throws up some fairly startling data. Mr Ibbotson, fellow academic Zhiwu Chen, and research analyst Wendy Hu compared various investment styles, studying 3,500 stocks backtested between 1972 and 2009. In their working paper, Liquidity as an Investment Style, they've found that a liquidity approach to picking stocks actually trumps other investment styles including size, value, growth and momentum. That is, picking less liquid stocks outperforms other investment styles, sometimes by a fairly wide margin.
This goes against the grain of what advisers and bankers are increasingly telling clients. Among private clients, for instance, liquidity is a criteria - but in the opposite sense. Since the 2008 crisis when the sudden drying up of liquidity caused distressed selling, conventional wisdom today is that liquid assets should form the bulk and core of the portfolio, and illiquids should have a smaller weighting. Mr Ibbotson and Mr Chen are co-founders of Zebra Capital Management, which was set up in 2001 to apply a 'research advantage towards providing better risk-adjusted returns'. Mr Ibbotson sold his consulting firm Ibbotson Associates to Morningstar in 2006. Zebra Capital is launching some funds based on the research. Two funds have been launched by US mutual fund firm American Beacon with Zebra Capital as sub-adviser.
In the research, the proxy for liquidity is annual turnover, or the number of shares traded divided by a stock's outstanding shares. Looking at size or market capitalisation against turnover, for instance, the research finds that micro-cap stocks with low turnover actually returned a stunning 17.87 per cent, against 5.92 per cent for micro-cap stocks with high turnover.
In the large cap universe, the performance differential narrows considerably to a 2.82 percentage point premium. That is, the least liquid large cap stocks returned 12.29 per cent, against a return of 9.47 per cent for the most liquid large cap stocks.
In the growth/value continuum, high growth is defined as the lowest earnings/price quartiles; and conversely high value refers to the highest earnings/price quartiles.
In this analysis, highly liquid growth stocks fared the worst with just 3.32 per cent annualised return, compared to 11.36 per cent for the least liquid growth stocks.
The least liquid value stocks returned 20.65 per cent, compared to 12.33 per cent for the most liquid value stocks. As for the screens of momentum and liquidity, among the best return of 16.76 per cent was generated by stocks with the highest momentum and lowest turnover. The worst performer were stocks with the lowest momentum and the most liquidity at 5.29 per cent.
Translating these findings into portfolio strategy, the research finds that the earnings-based liquidity strategy is the best performer, and it posits some reasons for this. This strategy combines two styles or factors - value and liquidity. 'This strategy favours the value style. The illiquidity bias makes the strategy favour stocks that have high earnings but a trading volume less than what its earnings would imply. The strategy bets more heavily in value stocks that have a low volume-to-earnings ratio, and it hence goes beyond fundamental value investing. And it pays to do so.' One of the reasons is fairly intuitive. Investors like liquidity and are willing to pay a premium for it. This pushes up the securities' prices and depresses expected future returns. 'By the same logic, illiquid or less liquid securities are valued lower, resulting in a higher expected return . . . When the earnings based liquidity strategy invests more heavily in less liquid value stocks, the strategy is rewarded with higher future returns because it provides liquidity to the market by being more willing to take larger positions in illiquid stocks.'
Meanwhile, EDHEC Risk Institute has published a paper of its findings on socially responsible investing (SRI) funds in France. It has found no evidence that SRI funds create financial value.
EDHEC finds that the majority of SRI funds, which includes green funds, produced negative and non-significant alpha. The funds were studied over eight years until December 2009. It also studied the funds over a shorter period between 2007 and 2009, which was a crisis period. It found that the financial crisis raised the extreme risks of SRI funds considerably. 'It is clear that on average, these funds provide no protection from market downturns.' EDHEC said the SRI universe has expanded even through the crisis, 'seeking to offer investors the image of a reliable investment that can withstand extreme volatility better than conventional investments'.
It said the concept of SRI has evolved, from the original ethical exclusion funds based purely on moral principles. It has extended to best-in-class funds based on environmental, social and governance criteria. More recently, funds based purely on environmental concepts have emerged and are growing rapidly in number.
