Liquidity as an Investment Style Roger G. Ibbotson Chairman & - - PowerPoint PPT Presentation

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Liquidity as an Investment Style Roger G. Ibbotson Chairman & - - PowerPoint PPT Presentation

May 02, 2023 43 likes •348 views

Liquidity as an Investment Style Roger G. Ibbotson Chairman & CIO, Zebra Capital Management Professor in the Practice Emeritus of Finance, Yale School of Management 2014 Updates Provided By Daniel Y.-J. Kim Research Director Zebra Capital

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Liquidity as an Investment Style

Roger G. Ibbotson

Chairman & CIO, Zebra Capital Management Professor in the Practice Emeritus of Finance, Yale School of Management

2014 Updates Provided By Daniel Y.-J. Kim

Research Director Zebra Capital Management

Asset Management Forum

“Liquidity as an Investment Style” Roger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim, and Wendy Y. Hu Financial Analysts Journal May/June 2013

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SLIDE 2

Liquidity as an Investment Style

Sources: CFA Institute, 2/20/2014 press release.

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What is Meant by Liquidity?

Liquidity in the Financial System

– High Savings Rates – Low Interest Rates – Easy Access to Capital

Liquidity in Trading

– Low Transactions Costs – High Trading Volume – Low price impact for Large orders

Liquidity in Valuation

– Pay extra price for liquid securities – Extra expected returns for less liquid securities

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Liquidity and Valuation

Liquid securities

  • Easier to trade with lower market impact costs
  • Higher priced for same set of cash flows
  • Desired for rapid turnover investors

Less Liquid securities

  • More difficult to trade
  • Lower priced for same set of cash flows
  • Higher expected returns, great for longer term investors

“Don’t pay for liquidity you do not need”

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$1 $10 $100 1980 1985 1990 1995 2000 2005 2010

The Liquidity Premium

1980 – 2013

Stocks, Bonds, Bills and Inflation

  • First highlighted traditional market premiums
  • Equity, value, size and liquidity premiums

What is the Liquidity Premium?

  • More liquid assets are priced at a premium
  • Less liquid assets are priced at a discount, thus having

higher expected returns

Foundation in Academic Literature

  • Thirty years of literature supporting higher returns
  • Ibbotson, Chen, Kim & Hu, 2013
  • Idzorek, Xiong, & Ibbotson, 2012
  • Pastor & Stambaugh, 2003
  • Datar, Naik & Radcliffe, 1998
  • Amihud & Mendelson, 1991
  • Ibbotson, Siegel & Diermeier, 1984
  • Impetus for investments in venture capital, private equity, and
  • ther alternative investments

Growth of $1

  • Source Low Liquidity and High Liquidity: Ibbotson, Chen, Kim & Hu, “Liquidity as an Investment Style” Financial Analysts Journal, May/June 2013.
  • Data update Zebra Capital.

Compound Annual Return Low Liquidity 15.57% Russell 3000 Value 12.33% Russell 3000 Index 11.66% Russell 3000 Growth 10.62% High Liquidity 8.45% ML 3 Mo T Bills 5.33%

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Why is Liquidity a Style?

William F. Sharpe (FAJ 1992) Investment Style Criteria Liquidity

  • 1. “Identifiable before the fact” Investors prefer liquidity and therefore there is a strong

economic justification “before the fact”

  • 2. “Not easily beaten”

Our results show that less liquid stocks have higher returns with lower volatility than more liquid stocks

  • 3. “A viable alternative”

Liquidity differs from other accepted styles with more than comparable premiums (size, value, & momentum)

  • 4. “Low in Cost”

Portfolios are stable and can be managed with infrequent rebalancing and low cost 6

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Study Methodology

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

trade

Selection Performance

T

Selection Performance

T

1972 1971 1973 2013

Selection Performance

T

2012

Broad U.S. stock universe ranked by size, value, momentum, liquidity

Up to 3500 U.S. stocks, 1972-2013

  • Size measured by year-end capitalization,

value measured by E/P ratios, momentum measured by previous year returns

  • Liquidity measured by share turnover
  • Matrixes independently sorted into quartiles

with equally weighted returns in each cell

  • Annual rebalancing

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U.S. Quartile Portfolios

1972-2013

$702 $402 $245 $220 $166

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Standard Deviation Annualized Return

15.35% 14.72% 12.72% 8.08%

20% 22% 23% 28% 0.75 0.68 0.55 0.29

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0% 5% 10% 15% 20% 25% 30% 35%

Low Relative Liq. Low to Mid Mid to High High Rel. Liq.

Annualized Return Standard Deviation Return to Risk Ratio

Liquidity Quartile Portfolios

1972-2013

  • Low liquidity outperforms

with less risk

Return To Risk Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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13.99% 12.74% 12.72% 11.69%

27% 24% 22% 18% 0.52 0.52 0.59 0.64

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0% 5% 10% 15% 20% 25% 30% 35%

Micro Cap Small Cap Mid Cap Large Cap

Annualized Return Standard Deviation Return to Risk Ratio

Size Quartile Portfolios

1972-2013

  • Small caps outperform,

but at a higher risk

Standard Deviation Annualized Return Return To Risk Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Liquidity

Liquidity Premium Low High

1 2 3 4 Q1–Q4

Size

Micro

1 16.3% 16.9% 11.1% 1.5% 14.8%

Small

2 15.9% 14.9% 12.6% 6.5% 9.4%

Mid

3 14.3% 14.3% 13.1% 8.7% 5.6%

Large

4 11.8% 12.3% 11.9% 9.2% 2.6%

Size Premium

Q1–Q4 4.5% 4.7%

  • 0.8%
  • 7.7%

Size vs. Liquidity

1972-2013

Within each market cap class, relatively low liquidity

  • utperforms.

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Small-Cap Liquidity Portfolio

1972-2013

Annualized Alpha Market M-RF Size Value Momentum R2 2.92%* 0.71 0.77 0.48 0.01 78.1% Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

*t-stat = 2.28 (Statistically significant at 5% level).

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16.89% 14.22% 10.87% 8.72%

23% 20% 21% 29% 0.73 0.71 0.51 0.30

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0% 5% 10% 15% 20% 25% 30% 35%

High Value Mid Value Mid Growth High Growth

Annualized Return Standard Deviation Return to Risk Ratio

Value Quartile Portfolios

1972-2013

  • Value beats Growth
  • Growth is the most risky

Standard Deviation Annualized Return Return To Risk Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Liquidity

Liquidity Premium Low High

1 2 3 4 Q1–Q4

Value

Value

1 19.3% 17.5% 16.6% 10.8% 8.5% 2 15.4% 15.0% 13.3% 12.4% 3.0% 3 13.4% 12.9% 10.8% 7.2% 6.2%

Growth

4 11.0% 13.3% 9.6% 3.4% 7.6%

Value Premium

Q1–Q4 8.3% 4.2% 7.0% 7.4%

Value vs. Liquidity

1972-2013

Both liquidity and value predict returns.

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Value-Based Liquidity Portfolio

1972-2013

Annualized Alpha Market M-RF Size Value Momentum R2 5.66%* 0.72 0.56 0.56

  • 0.03

81.9%

*t-stat = 5.31 (statistically significant at 5% level).

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Momentum Quartile Portfolios

1972-2013

Standard Deviation Annualized Return Return To Risk Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

13.70% 14.94% 14.00% 8.13%

23% 20% 21% 29% 0.59 0.76 0.67 0.28

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0% 5% 10% 15% 20% 25% 30% 35%

Big Winners Mid Winners Mid Losers Big Losers

Annualized Return Standard Deviation Return to Risk

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Liquidity

Liquidity Premium Low High

1 2 3 4 Q1–Q4

Mom.

Winners

1 16.9% 16.1% 13.8% 9.3% 7.6% 2 16.6% 16.1% 14.1% 9.8% 6.8% 3 15.6% 15.3% 13.6% 8.8% 6.8%

Losers

4 11.3% 10.4% 8.6% 4.0% 7.3%

Momentum Premium

Q1–Q4 5.6% 5.7% 5.3% 5.3%

Momentum vs. Liquidity

1972-2013

The liquidity premium is consistent within each momentum quartile.

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Momentum-Based Liquidity Portfolio

1972-2013

Annualized Alpha Market M-RF Size Value Momentum R2 2.06%* 0.79 0.74 0.30 0.23 85.9%

*t-stat = 1.93 (statistically significant at 5% level, one-tailed test)

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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Style Premia

1972-2013

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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2.30% 8.17% 5.57% 7.27% 9%

  • 6%
  • 6%
  • 8%
  • 10%
  • 5%

0% 5% 10%

Small minus Large Cap Value minus Growth High minus Low Momentum Low minus High Liquidity

Excess Return (Q1 - Q4) Change in Risk (Q1 - Q4)

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Liquidity Regressions on Factors

1972-2013

Annualized Alpha Market M-RF Size SMB Value VMG Momentum HML R2

Long/Short Liquidity Factor

4.28%*

  • 0.44
  • 0.40

+0.58 +0.13 71.4%

Low Liquidity Long Portfolio (R-RF)

2.30%* +0.74 +0.56 +0.44 0.00 88.3%

Liquidity can be expressed as a long/short or a long only factor.

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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*t-stats = 3.25 and 2.79 (both statistically significant at 5% level.)

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+4.41% +7.05% +7.24% +7.34% +6.64% +3.63% +7.61% +3.67% +4.08% +3.89%

  • 13%
  • 12%
  • 9%
  • 7%
  • 9%
  • 3%
  • 7%
  • 8%
  • 3%
  • 8%
  • 15%
  • 10%
  • 5%

+0% +5% +10%

R1K R2K CAN FRA GER GBR ITA SUI AUS JPN

Liquidity Premium (T1-T3) Change in Risk (T1-T3)

Liquidity Premia - Global (USD)

Jan 2000 – Sept 2013

Source: Zebra Capital Research.

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Two Reasons for Investing in Liquidity

Less Liquid stocks trade at a discount to more liquid stocks

  • Buying Less Liquid stocks means that the same cash flows

can be bought cheaper

Liquidity is mean reverting

  • Stocks move in and out of favor; as liquidity rises (falls),

valuations rise (fall) 22

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What Happens to Low Liquidity Stocks 1 Year Forward?

1 2 3 4

1 Low Liquidity 2 3 4 High Liquidity 1 Low Liquidity

1.08% Migrate to Quartile 4 +109.83% Return 3.41% Migrate to Quartile 3 +61.86% Return 17.44% Migrate to Quartile 2 +26.43% Return 78.07% Stay in Quartile 1 +10.74% Return

Q4 Q3 Q2 Q1

Source: Ibbotson & Kim, 2014 Update, “Liquidity as an Investment Style” [Ibbotson, Chen, Kim & Hu, FAJ 2013.]

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  • In theory and practice, less liquid stocks outperform.
  • But…measured by turnover, less Liquid stocks have lower risk

Sources: Ibbotson & Kim, “Risk & Return Within the Stock Market: What Works Best?,” Working Paper, January 2014; Yakov Amihud, “Illiquidity and Stock Returns: Cross-section and Time-series Effects,” Journal of Financial Markets. 5 (2002), p.31-56.

Amihud [2002] Turnover

shares traded shares outstanding

Quartiles 1972-2013 Geometric Mean Standard Deviation

Less Liq 14.74% 24.60% More Liq 10.77 19.35 Lower 14.87 19.81 Higher 7.64 27.90

Amihud Turnover

Is Turnover a “Pure” Liquidity Measure?

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Liquidity and Popularity

Source: Ibbotson & Kim, “Risk & Return Within the Stock Market: What Works Best?,” Working Paper, January 2014.

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  • Amihud may be a better

“pure” liquidity measure

  • Turnover may also

capture “popularity”

  • Less Popular Stocks
  • utperform with less risk
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Conclusions

Liquidity meets the Sharpe Criteria for an Investment Style

  • Strong economic justification (“before the fact”)
  • Higher long-run returns
  • Returns differ from size, value, and momentum
  • Portfolios are relatively stable over time (“low cost”)

Similar to risk, Liquidity should be managed

  • Investors should relate portfolio liquidity to time horizons
  • Changing stock liquidity creates return opportunities

The Liquidity Style Improves Your Portfolio

  • Higher Return
  • Lower Beta & Standard Deviation
  • Low Correlation of excess returns

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Liquidity as an Investment Style Appendix

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Liquidity of Mutual Fund Holdings

Feb 1995 – Dec 2009

U.S. Equity Fund Styles Annual Return Quintiles

Value / Growth

Value Blend Growth 1 2 3

Size

Large 1 7.35% +2.33% 6.86% +1.65% 6.68% +1.75% Mid 2 9.73% +3.25% 9.61% +3.19% 8.38% +3.18% Small 3 9.91% +2.77% 9.29% +3.32% 7.77% +3.00%

Mutual Funds with relatively less liquid holdings

  • utperform.

Category Compound Annual Return Excess Return From Liquidity (Quintile 1 minus Quintile 5)

Morningstar Style Box

Source: Idzorek, Xiong and Ibbotson, 2012, “The Liquidity Style of Mutual Funds,” Financial Analysts Journal 41(3):401-439.

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Liquidity

Liquidity Premium Low High

1 2 3 4 Q1–Q4

Beta

Low

1 15.3% 14.4% 11.9% 3.4% 11.9% 2 16.3% 15.0% 13.8% 10.5% 5.8% 3 13.7% 14.7% 13.3% 9.9% 3.8%

High

4 11.4% 12.0% 10.5% 6.4% 5.0%

Beta Premium

Q1–Q4 4.0% 2.4% 1.4%

  • 3.0%

Beta vs. Liquidity

1972-2013

Source: Zebra Capital Management

29 Liquidity explains

  • utperformance

more than low beta does.

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Liquidity

Liquidity Premium Low High

1 2 3 4 Q1–Q4

Vol

Low

1 14.1% 14.0% 12.7% 10.9% 3.2% 2 15.6% 14.4% 13.9% 12.1% 3.5% 3 16.1% 15.4% 13.5% 10.4% 5.8%

High

4 14.9% 14.1% 8.7% 2.6% 12.3%

Volatility Premium

Q1–Q4

  • 0.8%
  • 0.1%

4.00% 8.3%

Volatility vs. Liquidity

1972-2013

Liquidity explains

  • utperformance

more than low volatility does.

Source: Zebra Capital Management

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