• Stock Strategies
  • The Liquidity Style: Finding Bargains by Seeking Less Popular Stocks

    by Roger Ibbotson

    Roger Ibbotson is chairman and CIO of Zebra Capital Management and a professor at the Yale School of Management. We spoke about his studies on the relationship of liquidity to returns. A copy of a recent paper he co-authored on the subject, “Liquidity as an Investment Style,” can be downloaded at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1817889.

    —Charles Rotblut, CFA

    Charles Rotblut (CR): I’d like to discuss your studies on liquidity as an investment style. Can you explain what liquidity is in terms of stocks and shares trading?

    Roger Ibbotson (RI): Liquidity has many different definitions. People think of liquidity as something talked about after the financial crisis, or liquidity in the financial systems or liquidity in trading costs. What we are particularly interested in, though, is how liquidity affects valuation—particularly for longer-term investors. If they’re not going to do much trading, investors in fact can get a benefit from buying stocks that are traded less, but have lower valuations, which is what leads to the higher returns.

    CR: So you’re looking at stocks with less volume then, correct?

    RI: Well, there is more than one measure of liquidity, but the research papers I worked on that you mentioned looking at are based on trading volume. But whatever measure you use, it is true that the less liquid stocks have lower valuations and, ultimately, higher returns. You’re probably looking at two papers: My paper with Thomas Idzorek and James Xiong (“The Liquidity Style of Mutual Funds”), which was published in the November/December 2012 issue of the Financial Analyst Journal. And the other one is “Liquidity as an Investment Style,” which I co-wrote with Zhiwu Chen, Daniel Kim and Wendy Hu. That paper is also accepted by the Financial Analyst Journal, but it is forthcoming; I don’t know the publication date.

    CR: You looked at share turnover, specifically, over a 12-month period, correct?

    RI: Yes, we did look at turnover over the previous 12 months, and that is certainly one good measure of liquidity. That actually picks up popularity as well as liquidity. You can view the less liquid stocks as the less popular stocks as well. Ultimately, you’re basically buying the types of stocks that other people aren’t so interested in. In fact, that’s how you get your bargains in the market: You buy the types of securities that other people do not want.

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    CR: When you factored in turnover, were you looking at total shares outstanding or were you looking at the float, which is shares outstanding less the restricted shares?

    RI: We were looking at total shares outstanding to calculate turnover: number of shares traded divided by the total number of shares outstanding. Closely held companies, for example, don’t have that much float. But they also tend to be less liquid for that reason and they tend to be undervalued as well.

    CR: You noted that there are other measures of liquidity, such as the dollar value of the shares traded each month. Do you think there is an advantage of one method over another?

    RI: We like using turnover as a method; it is a simple, very straightforward method. Whatever method you use, you’re going to get the result that stocks that are less liquid have lower valuations and higher returns.

    CR: For calculating turnover, you’re looking at average volume over the last 12 months, correct?

    RI: In those academic papers, yes. It is part of my job at Yale School of Management to publish papers. At Zebra Capital, we also manage money based on buying these less liquid and less popular names. And we actually short the companies that are most liquid and most exciting—the glamorous-type stocks that everybody else is so interested in.

    CR: Are you using the 12-month period for that as well or a shorter period?

    RI: We tend to use the longer periods. We don’t always use 12 months, but we tend to use longer periods to measure liquidity. It turns out that shorter periods are really pairing up with changes in liquidity, and liquidity isn’t always going in the same direction. For example, you can have a company where as its liquidity rises, its valuation rises. If you take a short-term measure of liquidity, you may be picking up block trades or something like that and then they would tend to revert back down. So, a short-term measure of liquidity may quickly revert; a longer-term measure has a much slower reversion.

    CR: In the paper you mention changes in liquidity for a stock with high levels of turnover, where slowing volume would hurt its price and accelerating liquidity would tend to help the price. Is this where the short-term factors come more into play?

    RI: Yes. In fact, it can work in the opposite direction because the more liquid a stock becomes, the more its valuation rises. Of course, you want to buy before the rise in valuations.

    CR: Absolutely. You made an argument in your paper that you view liquidity as being a different investing style than valuation or market capitalization. Could you expand on this?

    RI: I don’t know if the market itself is a style, but that’s one of the big drivers of returns: whether the market is up or down. Beyond that, the two prominent investing styles that have been accepted are size and value. Small-capitalization stocks outperform large-capitalization stocks and value stocks tend to outperform growth stocks. These have been well-established in literature. We show in the paper that liquidity is different than either one of those, but really additive to them. So, if you buy a less liquid value stock, it will have higher returns than if you buy a more liquid value stock. Whether you’re talking about a value stock or a growth stock, the less liquid version tends to have the higher returns.

    [Editor’s note: Figure 1 shows the total return wealth indexes for the liquidity, value, growth and market investing styles.]

    CR: Usually that applies across market capitalizations as well, correct? A less liquid large-cap stock will hold up better than a large-cap stock that is actively traded?

    RI: Yes, a large-cap, highly actively traded stock will tend to perform less well than a large-cap stock that is more ignored by the market. But I will say that the spreads are bigger as you go to micro caps. As you go to the small micro caps, the return difference between the less liquid and the more liquid is higher.

    CR: Do you have a table that describes annualized returns across cap size ranges for different levels of liquidity?

    RI: Yes, we have a table showing quartiles of size. [Editor’s note: See Figure 2.] In quartile one, which is the top row of the matrix, you can think of those as being micro-cap stocks. You will see the “liquidity premium,” or the spread between the low liquidity and high liquidity columns, is very high. But you’ll also see a spread that is statistically significant even in the large caps, which would be row 4.

    CR: You looked at the 3,500 largest stocks. Do you get similar results with different stock universes?

    RI: You see this across the whole market. We have done other studies with a smaller number of stocks: At Zebra Capital, we manage global portfolios, but in the U.S. we usually hold the top-2,000 stocks. You find it across the whole spectrum of stocks. It is true that the differences are bigger with the smaller-cap stocks, but they are still substantial even within the larger-cap stocks.

    CR: In terms of holding period: If someone is using liquidity as an investing style, is it like any other style where if they see the attribute that makes the stock attractive and as long as the stock stays attractive, they should be willing to stay in it? Or are there signs they should be looking for, like a “liquidity trap”?

    RI: Yes, it is true that you will not win every year on a portfolio and certainly not with every stock. Just as with size or value, you do not win every year. It is the same with buying less liquid stocks. These types of stocks would win on average, but there would be times when this strategy would not succeed.

    CR: Is there a certain type of market that you’ve noticed is better or worse for less liquid stocks, or is it more of a secular trend?

    RI: Well there’s a worse time to try to buy less liquid stocks, which is in bubbles. In bubbles, for example the technology bubble of the late 1990s, people don’t buy on their fundamental values. They buy on excitement. And the stocks that are the most glamorous stocks, whether they have any real business or they just have potential promises of business, those kind of stocks do very well in those kind of markets. So in bubbles, the liquidity strategy definitely underperforms. When bubbles pop, however, that’s when less liquid stocks have the very best performance because that’s when valuations get back to more normal levels.

    CR: If an individual investor wanted to build a strategy incorporating liquidity, what should he pair it with? Should he be looking at valuation and momentum? Are there certain criteria that pair well with liquidity?

    RI: We pair it with value-type measures. You have to pair it with something because you really need to be buying fundamentally strong companies. You want to buy fundamentally strong companies that basically haven’t been recognized as such. So when you’re getting the less liquid stocks, they also are the less popular stocks. If they have strong fundamentals, but are less popular, these stocks tend to be selling at discounts. When the market recognizes more what’s going on, these stocks tend to migrate to becoming more popular. Then, if their fundamentals improve from there, they’ve got a double-whammy: improving fundamentals and the increase in popularity—this often creates very good returns.

    CR: I’d like to talk to you about the book that bears your name, the Ibbotson SBBI Classic Yearbook (which is now published by Morningstar). A lot of people focus on the long-term return data that starts in 1926. Is there a particular reason why that date is used?

    RI: I was in the Ph.D. program in the Graduate School of Business at the University of Chicago at the time, which is now called Chicago Booth. I was a Ph.D. student and then a professor there. Lawrence Fisher and James Lorie had put together data on the stock market going back to 1926. While I was working in the investment office at the university, people were always asking when they were going to update their studies. After they asked enough times, I decided that I would undertake that. We did it a little differently than Fisher and Lorie did, but we updated the studies. I was also very aware that there were different types of stock and bond premiums and we wanted to capture all of these premiums. We started in 1926 because that’s when Fisher and Lorie started their studies.

    I will say that there is some rationale to that. First of all, the data wasn’t available in detail much before that date. Secondly, we certainly wanted to capture the Great Depression because if you really want to know what is going on in long-term returns in the stock market, you can’t ignore what happened in the 1930s. With that said, we didn’t want to start immediately at the Great Depression. We needed to start some time before that.

    CR: If you picked a different starting date than 1926, you’d end up with a long-term return that is different than the 9.8% for large-cap stocks. But you’re arguing that it is important to use that date because it does include the Great Depression, correct?

    RI: Yes, if you started after the Great Depression, the return of course would be quite a bit higher. But you definitely want to capture a wide range of events. Now if you look at the period from 1926 on, you’re actually capturing two drops in the 1930s: the crash of ’29, which carried onto 1932; and then in the late 1930s there was another big drop in the stock market. We also had the drop in 1973 and 1974. We had the drop in the tech bubble in the beginning of this century. And then we had the financial crisis. These are the five big drops in the stock market and they’re spread out over a lot of different years. You need a lot of years to capture what is going on.

    CR: I know you’ve researched a lot of long-term data over the years on the market. Do you have any insights or anything you’ve realized from the data that individual investors should pay attention to?

    RI: You want to be a long-term investor. Actually, individuals have a tendency to go in the wrong direction. For example, if you look at the mutual fund flows, individuals got out after the financial crisis, but are only now starting to get back in to the stock market. They didn’t get completely out, but they had negative outflows during this whole time. Meanwhile, the stock market more than doubled and totally recovered from the financial crisis, and yet individuals were generally going against the grain and were reluctant to move back in to the market—with full force, anyway. So, I think the key is that, yes, it is true that the stock market has lots of risks, but if you want to get the returns of the stock market, you have to really stick with it. You can’t bail out when times are the toughest.

    CR: Is there anything else that I haven’t asked you that you think is important to bring up?

    RI: There is one table in my paper with Thomas Idzorek and James Xiong “Liquidity Style of Mutual Funds” that looks at the Morningstar style box, which is probably the best summary of what is in this paper. [Editor’s note: The data is reproduced in Figure 3.] We show that mutual funds that hold less liquid stocks outperform mutual funds that hold more liquid stocks in every one of those nine cells/categories. And the outperformance tends to be about 2% to 3% a year. This is something that I think individual investors have pretty much immediate access to. If they buy the mutual funds that are holding the less popular and the less liquid stocks, there’s a pretty substantial extra return that they can have. Another reason I think this table is so important, other than just the fact that the returns are higher, is that it refutes the idea that if you’re going to buy a less liquid stock then you’re going to have higher transaction costs. That table looks at these mutual funds after all the transaction costs. It looks at the mutual funds after all of the fees that mutual funds might charge. So even after all of the transaction costs and fees, there’s still this 2% to 3% extra return that you get by buying mutual funds that hold the less liquid holdings.

    CR: You’re saying that investors are being compensated for the wider spreads between the bid and the ask prices, correct?

    RI: Yes. So it’s not only true that you have higher gross returns, but you have higher net returns—net of all costs. And it’s interesting, like with a lot of styles, the mutual fund managers in the sample were not even aware of what we were categorizing. They’re not even aware that they’re holding the less liquid stocks; at least they’re not purposely trying to do that. We’re just dividing them into quintiles so that we can compare the mutual funds that hold the lowest liquidity quintile stocks with the mutual funds that hold the highest liquidity quintile stocks. So they’re accidentally falling into these categories; they’re not trying to do it. If you try to do it, you might actually do even better than they do on this. So we think that particular research paper shows something that is definitely relevant to individual investors.

    CR: So if you’re an individual investor looking for those funds, would it just be a matter of legwork on your part looking at what the top holdings are and then trying to determine which funds hold less liquid stocks and which are going after the more popular stocks?

    RI: Yes, there may be a lot of legwork. We do sub-advise two mutual funds from American Beacon: American Beacon Zebra Global Equity (AZLPX) and American Beacon Zebra Small Cap Equity Fund (AZSPX). So I guess one could get our strategy without going through all of that legwork.

    Roger Ibbotson is chairman and CIO of Zebra Capital Management and a professor at the Yale School of Management.


    Jonathan Kahn from IN posted over 3 years ago:

    Your discussion is interesting, but I am not certain what types of companies you are referring to. Can you provide some examples of what might be consider large cap liquid stocks versus less liquid or illiquid, and do the same for mid or microcap groups? Thanks.

    Prem Jindal from PA posted over 3 years ago:

    Iwonder if Dr. Cloonen, shadow stocks fall within catagory of low liquidity/ microcap stocks and that why these are performing good.
    Thanks and also can you please provide the forthcoming article on " liquidity as an invesment style.
    PREM C.JINDAL(jindalprem@yahoo.com)

    Patrick Shanahan from KY posted over 3 years ago:

    Does Professor Ibbotson have a newsletter or advisory blog with recommendations?

    Brad Rogers from VA posted over 3 years ago:

    Are there any ETF's that use this strategy? it sounds promising.

    Mike Ginn from CA posted over 3 years ago:

    It looks like (from Figure 1) that this effect is only significant from 2000 to 2005. If true why is this, and does it make sense to use an investment strategy which has only really added a lot of value in 5 of the last 32 years?

    Frederick Joffe from KY posted over 3 years ago:

    Where does one find tables on liquidity or turnover for individual stocks?

    D. Albert from virginia posted over 3 years ago:

    Perhaps I missed it, but I did not see where the professor addressed the issue of attrition. Small cap companies go out of business at a far greater rate than mid & large cap. Without accounting for rates of attrition, the findings would appear to be less credible.

    Charles Rotblut from IL posted over 3 years ago:


    In his paper, Roger wrote, "Second, a stock must have available information on trading volume and monthly total returns, earnings, number of shares outstanding, and stock price, for all 12 months of the selection year." So, the aspect of attrition was factored into the results.

    Plus, note that the liquidity premium applies to both mid-cap and large-cap stocks as well.


    George from MA posted over 2 years ago:

    The paper has an interesting viewpoint. However, I was unable to verify the theory using the mutual fund AZSPX that is mentioned in the paper. In fact, the returns of AZSPX (from inception)and SPY are very much the same, the standard deviation is lower for SPY and the expenses on SPY is significantly lower, 0.1% versus 1.37%.
    Mr Rotblut, it would be helpful to verify the data on the funds mentioned?. If your data agrees with mine, it would be interesting to get Prof Ibbotson's reply.
    (The data I used was the Adjusted Close from Yahoo finance)

    Kenneth Bernard from MI posted 9 months ago:

    Great interview. The link for the publication didn't seem to work:
    Is that still active?

    Charles Rotblut from IL posted 9 months ago:


    Roger has a list of his publications on his Yale webpage: http://som.yale.edu/roger-g-ibbotson.


    Shane Milburn from TN posted 7 months ago:

    In practice the strategy of the low liquidity funds mentioned has done fairly poorly since fund started in 2010. The global fund AZLPX compares unfavorably to Vanguards VT. The small cap fund AZSPX compares unfavorably to Russell 2000.

    I know that going back to fund inceptions in 2010 doesn't provide alot of data, but the gaps are large and nearly 6 year can't totally be ignored I don't think. It makes me wonder if publication of the idea has changed the market.

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