Quant Analysts Say People Have Stock Liquidity Premium All Wrongby
Change in liquidity strategy outperforming over last 20 years
Traders slow to see share turnover, leading to opportunities
Researchers at Standard & Poor’s have a new model for enhancing returns using levels of liquidity in individual stocks, and it’s not the one Wall Street uses.
It’s been a tenet of investing for years that you should get paid for owning illiquid stocks -- that they carry a higher risk premium, in the words of portfolio analysis, and should return more because of the hazards of owning them. That’s not quite right, according to Frank Zhao and Richard Tortoriello at S&P, who say the key is actually in identifying stocks where liquidity is rising.
The quant analysts in S&P’s Global Market Intelligence unit examined changes in market turnover, a liquidity measure that adjusts volume for share price. Over 20 years ending June 2015, the purchase of stocks where it had increased the most generated a 4.7 percent return, beating strategies focused on earnings yield and price momentum by at least 65 basis points, the data show.
“Quants are always looking for new inputs for their black boxes or models,” said Mark Luschini, chief investment strategist at Philadelphia-based Janney Montgomery Scott LLC, which manages $54 billion. “If that liquidity factor is, in fact, a determinant of price movement, that would be viewed as very valuable information to them.”
The factor works probably because investors don’t notice as a stock is going from relatively low to high liquidity, the period that should coincide with its price appreciating, if you accept that it had a risk premium built in. According to the researchers, the delay in perceptions makes it possible to buy after liquidity starts to rise and still make money.
Change in liquidity is “an alpha factor that’s not widely recognized,” Tortoriello, a quantitative analyst at S&P, said in a phone interview. “Therefore, the change in liquidity provides excess returns over time as investors start to see the benefit in owning that particular stock,” he said.
One of the ways researchers have historically assessed liquidity is through a measure of turnover, defined as a stock’s daily volume divided by its shares outstanding. They also consider the so-called Amihud measure, which looks at the impact of illiquidity on share prices. S&P takes it a step further, using the 12-month change for these two standalone methods as the basis for their conclusions.
They also looked at time periods ranging from six to 36 months, finding that they, too, were supportive of their thesis. Once liquidity in a stock starts to rise, increased turnover becomes a self-fulfilling prophecy, according to Zhao, a quantitative analyst at S&P.
“If stocks are already exhibiting rising liquidity, they do outperform,” Zhao said by phone. “And because there is persistence in this signal, our results suggest that as they get more liquid, they continue to outperform up to at least three months in the U.S. and international markets.”
Not only does investing based on rising liquidity deliver better returns, it’s also only loosely correlated to fundamental factors like quality, value and price momentum, insulating it from the twists and turns of a normal market cycle, according to the researchers.
In fact, when compared with those three strategies, the purchase of stocks with the biggest liquidity increases has shown a greater ability to generate excess returns relative to benchmarks. The measure, known as the information ratio, has been 0.45 over the last two decades, exceeding the next-closest factor by 32 percent over the period, S&P data show.
“The point is not just the degree of outperformance of the change in liquidity versus the other factors,” said Tortoriello. “We’re also looking to prove that liquidity stands on its own and has value in and of itself. An investment model could benefit from the addition of the change in liquidity.”
The S&P analysts based much of their research on a 2012 study from Fordham University Schools of Business, which found that the stock market under-reacts to stock level liquidity shocks.
While investing based on changes in liquidity is still a relatively unknown strategy, the researchers at S&P think it can be used to a greater degree. That’s particularly true for so-called “quantamental” investors who use fundamental factors as a screen before conducting quantitative diligence, according to Zhao.
“This is a strategy that will gain more and more visibility over time,” he said. “Institutional equity investors will show more interest because it works not only by itself, but there are also diversification benefits to be had by adding it to commonly-used stock selection strategies.”