By Peter Pearce
This is part of a series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling. For an introduction to the series and the book, see our previous article looking at the return drivers for stocks.
This article is an introductory piece explaining why and how to use a liquidity strategy as a distinct investment style in Myth #15 The Largest Investors Hold All the Cards. The key to building a truly top tier portfolio is to diversify across strategies that exploit different “return drivers,” as described throughout the book. As we’ll show later in the article, liquidity is one of the possible “return drivers” and including a strategy to capture it will improve your portfolio diversification. Liquidity trading strategies are simple because they rely on easily observable attributes, and are easy to implement. In fact, there are a couple of mutual funds that are designed to capture liquidity premiums, which can be quickly plugged into any portfolio.
When it comes to taking advantage of liquidity premiums, counter to conventional wisdom, it’s individual investors with their small size and flexibility that hold all the cards, not the large investors. There are a couple of good reasons for this:
First, most institutional investors (i.e. pension funds, insurance companies) are constrained by an investment mandate to invest only in stocks that have a market capitalization of a billion dollars or more. These stocks only make up one-third of all stocks traded on U.S. markets and therefore almost two-thirds of possible equity investments are off limits.
Second, institutional investors have huge portfolios of billions of dollars and need to commit at least tens of millions of dollars to a single security to hold any meaningful position in them. Smaller companies just don’t have enough volume each day to accommodate transactions of this size and allow institutional investors to build a position. For example, in this article, I described a trade that Michael Dever took to capitalize on plunging orange juice demand. This trade simply wouldn’t have been possible for an institutional investor because the orange juice futures market is too small for an individual to hold an adequate position.
So take advantage of your small size and flexibility! Look to capture premiums that institutional investors just simply aren’t able to because it’s an investment advantage that institutional investors can only dream about.
A liquidity strategy is one where we assign more weight to less liquid stocks and less weight to stocks that have higher liquidity. So in essence our strategy favours less popular stocks and is biased against “hot” stocks. It’s important to understand that liquidity is an investment style different from size, value/growth or momentum. The strategy captures a completely different return driver, which is what ultimately creates the diversification we’re looking for. To be sure, trading volumes typically favor large-capitalization stocks, but volume is relatively market capitalization-neutral as small-cap and large-cap stocks can have both low and high turnover rates. See the paper (pdf) “Liquidity as an Investment Style” (Ibbotson, Chen and Hu, 2007).
So what is the “return driver” that a liquidity trading strategy captures? It’s an “illiquidity premium,” which Yale Professors Ibbotson and Chen studied in the paper linked above. The study showed that the securities that had the lowest trading volume performed better than the more liquid stocks. Consider the graph below from "JackassInvesting," which shows the performance of 3,500 US stocks, from 1972 to 2009, organized by size and trading volume. Regardless of market capitalization, lower liquidity translated into higher annual returns, with small-capitalization stocks seeing the most dramatic difference between the most and least liquid stocks. You can see this as returns increase from right to left across the graph.
Academic literature (pdf) has identified size as a profitable investment style (“The Cross-Section of Expected Stock Returns,” Fama and French, 1993), which explains the returns increasing as you move from large- to small-cap companies. What the above graph shows is that liquidity is an even more important return driver than size.
Ibbotson and Chen provide three reasons for this “illiquidity premium.” First, liquid stocks sell at a premium and illiquid stocks sell at a discount because investors like liquidity and dislike illiquidity. Investors are willing to pay more for a security that can easily be converted into cash. Second, at a macro-economic level, the growing level of available capital in the market makes today’s less liquid securities more liquid over time as the liquidity of all securities grow. Therefore today’s illiquid stocks become liquid tomorrow and increase in value as the liquidity discount disappears. Third, at a micro-economic level, trading volume is a measure of the demand for a stock. If the stock is too “hot,” demand will be high and trading volume will also. This higher demand will cause the price of the security to push higher than justified by fundamental factors. By investing in low-volume securities, the liquidity strategy reduces its exposure to “speculative fever stocks” and increases exposure to “diamond in the rough” stocks.
Liquidity premiums are often priced differently during good economic times and bad economic times. In negative environments like bear markets, the market requires a higher premium for illiquidity. Investors needing to sell their illiquid stocks become liquidity takers and pay a steeper price to exit the position. On the other hand, investors who can provide liquidity during these bad times benefit by earning a larger liquidity premium. In short, the illiquidity premium increases during bear markets and decreases during bull markets.
There are two options to capitalize on this research. The first is to invest in mutual funds launched by Zebra Capital Management and American Beacon Advisors. These two funds, the American Beacon Zebra Large Cap Equity Fund (AZLPX) and American Beacon Zebra Small Cap Equity Fund (AZSPX) were launched in June 2010 and follow a liquidity strategy.
The back tested performance is positive:
Performance of AZLPX since inception compared with the Russell 1000:
Performance of AZSPX since inception compared with the Russell 2000:
The two funds have a very short performance history, and it’s left to be seen if they will outperform their respective indexes by a few percentage points. The early performance is relatively positive. I would recommend that most readers allocate a portion to these funds to include liquidity as a return driver in their diversified portfolio.
The second option is use a stock screening database to screen stocks that have the desired attributes. A quick note for more advanced readers who don’t plan on using the mutual funds: there are different measures of liquidity available for analysis. Bid-Ask spread, market depth, trading volume and price-impact per dollar traded are examples. The Ibbotson study examined a number of different measures and concluded that dollar trading volume relative to company earnings was the most profitable measure. We want to assign a positive weight on earnings but a negative weight on volume to find those that have low volume relative to their earnings. So compute Volume/Earnings for potential investments and examine those with a low ratio compared with similar companies.
For example, suppose you’re looking to add exposure to the U.S. Financial sector, Life Insurance industry, and are only interested in mid cap (capitalization between $2bln and $10bln) stocks. My favorite stock screener shows 4 potential investments: Genworth Financial (GNW), Lincoln National (LNC), Reinsurance Group (RGA) and Torchmark (TMK). Using a quick calculation of earnings (EPS * Shares outstanding) and the Average volume provided by the screener, I find:
*negative earnings for GNW exclude it from consideration
RGA has the lowest Volume/Earnings, which would indicate that, according to our strategy, it is the most favorable investment.
By no means am I suggesting that any of the stocks discussed here are a good investment. I’ve done no real analysis on them. This is simply an example to highlight how to use the Ibbotson research in selecting stocks. The study results demonstrate that an Earnings-based Liquidity strategy improves performance over an earnings or fundamental strategy (where we allocate according to fundamental variables such as earnings, sales, book value, etc..). I would recommend reading the Ibbotson & Chen study for more information.
To conclude, most institutional investors can’t enter into these markets because of their size, and are therefore unable to capture the liquidity premium. The premium is there to be captured by you, the individual investor. The back-tested results of the mutual funds that exploit this strategy look strong, but the funds have very short real performance histories. I’ve focused the discussion here on U.S. equities markets, but this liquidity premium exists in a wide variety of financial markets. Liquidity is just one return driver and a diversified portfolio should be created with a mix of several strategies based on different return drivers.
Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.