Liquidity may be more of a return predictor than you think, according to Roger Ibbotson, chairman and chief investment officer of Zebra Capital Management. During a presentation at IMCA’s New York Consultants Conference this week, Ibbotson made the case to advisors for a portfolio that is biased toward less liquidity, yet is still relatively liquid.
Through a study by Ibbotson, he found there was a relationship between the amount of risk taken in a portfolio, the liquidity and the returns. In other words, extra returns come from less liquidity and more risk.
More liquid assets are priced at a premium, while higher-return assets, such as private equity, real estate, and distressed debt, are typically less liquid.
“Don’t pay for the liquidity you don’t need,” he said. “You need the appropriate liquidity in your portfolio.”
In the study, Ibbotson looked at liquidity and returns across 3,500 U.S. stocks from 1972 to 2010. In the first scenario, he ranked the stocks by size (micro-cap to large-cap) and liquidity (turnover from low to high). Micro-cap stocks with the lowest level of liquidity performed the best on an annualized basis, returning 18.17 percent. But the micro-cap stocks with the highest liquidity had the lowest return, at 6.16 percent. Ibbotson found that liquidity dominated size as a return predictor.
Ibbotson also measured the liquidity-return relationship from a momentum standpoint, and found that both liquidity and momentum predicted returns. When he analyzed the liquidity-return relationship between value and growth stocks, he also found that value affected returns along with liquidity.
His best idea for taking advantage of the dynamic is to lean a portfolio toward less liquid stocks. These securities typically trade at a discount because investors don’t want them as much, he said. He suggested buying out-of-favor or boring stocks. The strategy works in almost any public market, including the U.S. and international, and can be used at various capitalizations, he added. In addition, liquidity is mean reverting; as liquidity rises or falls, valuations also rise or fall.
Liquidity return strategies are appropriate for investors who want higher returns and who have longer time horizons, Ibbotson said.
