The search for value often draws investors into illiquid markets, and to some, this can be a daunting prospect. However, research suggests that illiquid stocks outperform their liquid counterparts over the long-term.
In what has been called an illiquidity-anomaly, several studies published over the past few decades have shown that the market rewards illiquid stocks, although it’s unclear exactly why. One of the earliest studies on the topic was conducted by researchers Amihud and Mendelson who used bid–ask spreads to explain stock returns between 1961 and 1980. Published in 1986, ‘Asset Pricing And The Bid-Ask Spread’ raised some interesting points.
The data showed that average portfolio risk-adjusted returns increased with wider bid-ask spreads. Moreover, the data lead to a conclusion that the spread was by no means an anomaly or an indication of market inefficiency; rather, it represented a rational response by an efficient market to the existence of the spread.
It was found that due to the existence of a wide spread, investors held the illiquid stocks for a longer period and the wider spreads actually attracted investors who were willing to invest with a longer time horizon.
In other words, wide spreads encourage responsible long-term investing, not short-term speculation. Unfortunately, while a wider spread may lead to outperformance, a company’s cost of equity capital will be higher due to the wider spread. Clearly this is not desirable from a company’s point of view.
In the latter part of the 1990’s, two more studies were published that looked at the above average returns of low turnover stocks. These studies, conducted by Haugen and Baker (1996) and Datar, Naik, and Radcliffe (1998)demonstrated that low-turnover stocks, on average, earn higher future returns than do high-turnover stocks.
Illiquidity as a strategy
During 2013, Roger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim, and Wendy Y. Hu released a study that went so far as to say that illiquidity should be a style of investing, like growth and value. The study, entitled Liquidity as an Investment Style argued that:
“Liquidity should be given equal standing with size, value/growth, and momentum as an investment style. As measured by stock turnover, liquidity is an economically significant indicator of long-run returns. The returns of liquidity are sufficiently different from those of the other styles that it is not merely a substitute. Finally, a stock’s liquidity is relatively stable over time, with changes in liquidity associated with changes in valuation.”
Data from the study is shown below.
For his work on the topic of liquidity, Roger Ibbotson and his co-authors received the 2013 Graham & Dodd Prize for the best article in the Financial Analysts Journal.
Ibbotson’s study focused on daily stock turnover as a measure of stock liquidity. He looked at 3,500 U.S. stocks, ranked them by their turnover and then divided them into four quartiles. The least liquid quartile showed an average return of 16.38% per annum over the study period, 1972 to 2011. The most liquid quartile showed an average annual return of 11.04%.
Unsurprisingly, many of the stocks in the most illiquid quartile were cheap, value style stocks, which goes some way to explaining their outperformance — value tends to outperform over the long-term. But Ibbotson and his team also performed the same exercise for all other recognized styles. They found that while the performance of illiquid stocks could be explained by stocks’ cheapness, there was a significant statistical outperformance by illiquid stocks across all strategies that could not be explained. Over the full 1972-2011 period, illiquid stocks fared better than small stocks and high-momentum stocks.
Only a year before the above study was published, Roger Ibbotson published a smaller liquidity study in the Financial Analysts Journal, which dissected mutual funds.
This study looked at the holdings of U.S. equity mutual funds, offered for sale to U.S. residents, from February, 1995, to December, 2009. Each fund was classified according to its orientation on the value-growth spectrum and the liquidity of holdings. Liquidity was calculated by taking a stock’s average volume over the last year divided by its shares outstanding. In this study, value stocks outperformed growth by 0.80% per annum. Small-caps beat large caps by 1.89% per annum and small-cap value funds outperformed by 3.23% per annum.
The difference in performance between illiquid and liquid stocks was even wider. Value funds that held the least liquid 20% of stocks, outperformed value funds with the most liquid stocks by an average of 2.28% per annum. Illiquid growth funds also outperformed liquid growth funds by 2.25% per annum.
Funds holding the least-liquid small value stocks beat those with the most-liquid large growth stocks by 4.99% on average each year.
So, there is a certain amount of evidence that points to the fact that illiquid stocks outperform the market over the long-term. There’s also evidence to suggest that illiquid stocks are less likely to suffer dramatic drawdowns during periods of heavy selling, as the FT explores:
“As illiquid stocks should be harder and more expensive to trade, it becomes harder for share prices to readjust smoothly, creating volatility. But in practice, the experience of the 2008 crisis was exactly the opposite. Daniel Kim, one of the co-authors and research director for Zebra Capital Management in Connecticut, reports that illiquid stocks suffered far lower drawdowns during the most dramatic days of heavy selling. That was because, in an emergency, people sold whatever they could, so liquid stocks were sold first.”