New factor on the block: Research suggests you don’t need alternative investments to get an “illiquidity premium”

CAPM / Alpha Theory 02 Aug 2010

AllAboutAlpha.com was in Chicago last week moderating a panel at a conference on alternative investments hosted by Financial Advisor Magazine. Most conferences on the hedge fund/alternative investment circuit are designed for institutional investors and hedge fund industry players. With a focus on registered investment advisers, however, this one was a little different. As alternative investments continue their migration to the mainstream, this will surely become an increasingly important market for the hedge fund community.

There was a lot of buzz about the reported death of buy-and-hold strategies – the traditional bread and butter for America’s financial advisors. But many attendees were still coming to terms with the relative illiquidity of alternative investments (compared to mutual funds, for example). Some openly wondered – as we did in “Is the Vaunted Illiquidity Premium Partially an Illusion?” – how much of the “alpha” generated by illiquid investments was actually just an “illiquidity premium”.

While illiquidity and alternatives investments often go hand in hand, updated research presented by Roger Ibbotson at the conference showed that there is also an illiquidity premium in less-liquid stocks. In fact this premium can be so compelling that it rivals the premium usually associated with private equity and other super-illiquid investments.

Ibbotson and his Yale colleague Zhiwu Chen – who also co-founded a company set up to exploit this anomaly – compared the performance of low liquidity stocks with traditional Fama/French categories such as small cap stocks, value stocks, and momentum stocks. As expected, they found that abnormal performance of small cap stocks was higher than it was for large cap stocks. However, they discovered that this was only true for small cap stocks with a low level of liquidity (which is typical for many small cap stocks). But for small cap stocks with a high level of liquidity (think media darlings like dot-coms), the opposite was true. In that case, large cap stocks produced better returns. (See table below from his conference presentation that updates the paper above with data to the end of December 2009.)

As you can see from the chart below, the outperformance of value stocks was a little more consistent across the liquidity spectrum. In this case, value stocks outperformed growth stocks by around 10% across the board. However, for high liquidity stocks, this difference represented a 4-fold increase in abnormal returns (from around 3% to around 12%).

There is a wide consensus that the “momentum” factor has had one foot in the grave for some time. In fact, as Ibbotson pointed out in his Chicago remarks, it may have begun to be arbitraged away as early as the mid 1990’s. However, momentum stocks still seem to marginally outperform those without momentum. This modest outperformance is trumped, however, by the effect of liquidity. In other words, the outperformance of illiquid momentum stocks over highly liquid ones is much larger than the outperformance of momentum stocks over non-momentum stocks. So much for momentum… (See table below).

So what’s behind this phenomenon?  As Ibbotson points out, this isn’t new. Alternative investors have known for years that illiquid investments deliver higher returns. But they are used to measuring illiquidity in quarters and years, not minutes and hours. If you can extract an illiquidity premium from easy-to-trade public markets, why bother looking for it in alternative investments?  (Alternative investment managers might even agree, saying this premium is a by-product of their strategies, not the raison d’etre anyway).

The duo point to three reasons for this anomaly:

  1. The “Equilibrium Argument”: “By investing in illiquidity, the strategy serves as a liquidity provider and hence is compensated…Hence, depositors and consumers face “liquidity risk”, because of which they are willing to pay more for liquid investment vehicles.”
  2. The “Macro Argument”: “As a result of the financial revolution in America and beyond, more and more assets and future cash flows have been converted into financial capital that can be used or put into new investments today…as financial capital supply grows overtime, the high tide lifts all boats: all securities will have rising liquidity. It is, however, the least liquid stocks that receive the biggest benefit. Such rising liquidity makes past illiquid stocks valued relatively more today.”
  3. The “Micro Argument”: “If there is too much interest in the stock and the stock becomes glamorous, the trading volume will be high and turnover will be extraordinary too, pushing the stock price higher than justified by fundamentals…by avoiding or investing less in stocks that are popular and traded heavily and putting more capital in low volume-to-earnings stocks, the Earnings-Based Liquidity Strategy reduces its exposure to speculative fever risk and puts more weight on the ‘diamonds in the rough.’”

Whatever the reasons, Ibbotson and Chen say they can systematize the model to produce a long/short hedge fund (and a few mutual funds) that go long low liquidity stocks and short high liquidity stocks. (see Zebra Capital Management as proof).

If this investment strategy sounds familiar to you, you’re not alone. Many long/short equity managers do just that – they go long value stocks after conducting fundamental analysis and they short the high-flying darlings that tend to have a higher liquidity (since they’re assumed to be over-loved by markets – but also since they provide managers with a chance to escape a short squeeze if required).

So I asked Ibbotson whether his model could be used as a factor to add to his previous research aimed at defining hedge fund alpha (see related post). He had not yet done so, but left open the possibility. Regular readers may recall that Ibbotson and Chen have previously steered clear of using anything other than market betas in their previous work. But it looks like their liquidity factor may be a good candidate to add to the list of factors used to regress hedge fund (and active long-only) returns – maybe even to replace the ailing momentum factor.

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