Most people don’t think about it, but there is a liquidity premium on publicly traded securities just as there is a risk premium, yet most only think about it in the case of extremely illiquid assets such as private equity.
However the liquidity premium is separate and distinct and there is a way to manage it to your advantage. This is what Roger Ibbottson, the former chairman of Ibbotson and Associates, is into these days as Chief Investment Officer of Zebra Capital Management. Zebra manages portfolios and hedge funds with an eye to capturing this liquidity premium.
“Less liquid securities are more difficult to trade, but they’re lower in price for the same set of cash flows and that’s what gives you the higher returns,” he says. “The key is don’t pay for liquidity you don’t need.”
Liquidity is easier to see in bonds, where you can have two identical bonds, with one trading at a slightly lower price because it’s less liquid. This is less apparent with stocks, but according to Ibbotson, 30 years of academic research supports the fact that you can make higher returns with the same risk by purchasing publicly owned stocks that trade slightly less than say glamour stocks also are cheaper. Hence, Ibbotson explains, you are paying less for the same cash flows as a stock that might have higher visibility and more trading volume.
To demonstrate this, he shows the returns research spanning the period from 1972 to 2010 using up to 3500 U.S. stocks comparing degrees of liquidity versus stock size (micro cap to large cap), growth/value and momentum. In all cases the lower turnover stocks show significantly higher returns. For example, the lowest liquidity stocks in the microcap category returned 18.17% over the time period compared with only 6.16% for microcaps with the highest turnover. Likewise in the large cap category, the least liquid publicly traded stocks had 12.49% returns versus 9.87 for the most liquid.
“Less liquid stocks trade at a discount to more liquid stocks,” Ibbotson says. “Less liquid stocks have higher historical returns, beyond any size, value, or momentum effects.” This strategy, he claims works in almost any public market, including international equity, publicly traded real estate, high-yield debt and global bonds.
An interesting concept but how do you put it into practice? Well you can try buying stocks that are more kind of staid and boring but still publicly traded, or you could buy the mutual funds his company released last June: American Beacon Zebra Large Cap Equity Fund and American Beacon Zebra Small Cap Equity Fund. The press release announcing these funds describes their strategy this way: Zebra Capital “uses these observable, relative liquidity measures to construct a portfolio that invests more heavily in stocks with strong fundamentals that are traded less often than stocks with comparable fundamentals. The Funds’ strategy is designed to generate higher returns over time, driven by three factors: less liquid stocks generally trade at a discount; individual stocks move in and out of favor, reverting toward mean liquidity; and a potential benefit from general worldwide increases in the liquidity of markets.”
So far the strategy seems to be working. Returns for the Large Cap fund according to Zebra’s monthly reports are 23.8% compared with 19.98% for the Russell 1000 since June. For the month of January the fund returned the company’s monthly. The small-cap fund fared less well in a market that favored large caps but still beat its benchmark, returning 20.20% versus the 19.04% for the Russell 2000 since inception. January returns were 0.08 for the fund versus -0.26 for the Russell 2000.
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