June 15, 2010
The illiquidity premium
Let’s now turn to Ibbotson’s research on the liquidity premium.
On May 1, American Beacon introduced its Zebra Large Cap (AZLAX) and Small Cap (AZSAX) funds, which are sub-advised by Ibbotson and Zebra Capital. The underlying concept behind these funds is that there is a liquidity premium. Over time, illiquid securities generate higher returns than liquid ones, and the funds concentrate their investments in illiquid securities to generate alpha.
In the bond market, it’s fairly easy to observe the liquidity premium. Off-the-run Treasury securities are priced lower (and yield more) than on-the-run securities of equivalent maturity and coupon. Zebra has taken this concept and deployed it in the equity markets, where Ibbotson said he has found “surprisingly large liquidity premia.”
One way Zebra measures liquidity is through the V/E ratio, which is the trading volume of a company divided by its earnings. The lower the V/E ratio, the higher will be the liquidity premium. This metric supports the funds’ goal of buying stocks with strong fundamentals and earnings that Zebra believes are undervalued.
How much excess return can one expect from a low-liquidity strategy? To answer this, one must also control for factors such as market capitalization and value-versus-growth. Using data from 1972-2009, Ibbotson found, for example, a nearly 12% difference in average return among small-cap stocks between the lowest-liquidity quartile of stocks and the highest-liquidity quartile of stocks. Over the same time period, within value stocks, the lowest-liquidity quartile outperformed the highest-liquidity quartile by over 7%.
The liquidity premia were also present in large cap and growth stocks, as well as in high- and low-momentum stocks, to varying degrees.
For liquidity to be considered a unique factor, separate from market capitalization, growth/value, and momentum, it must also have a low correlation to those factors, and that has been the case. From 1996 to 2009, the large-cap fund had a -0.04 correlation to a market-cap strategy, a 0.22 correlation to growth/value, and a -0.45 correlation to momentum. For the small-cap fund, the correlations were 0.39, 0.10 and -0.44, respectively.
Before embracing these funds, advisors will want to answer several questions.
Can these results be replicated “out of sample”? As impressive as these results may be, they could still be the byproduct of data mining. A true out-of-sample test would require either replicating these results across multiple markets (other than US equities) or showing that they persist over a longer time interval.
How will the funds perform in a financial crisis or severe bear market? At such times, prices for illiquid securities are likely to be severely depressed. These open-ended funds will be vulnerable to redemptions by individual investors who panic or otherwise seek liquidity, forcing the funds to sell securities at precisely the time they would want to buy them. Zebra has run low-liquidity strategies in its hedge funds, where investors are presumably subject to lockups and the managers are free to pursue performance with a long-term time horizon. Open-ended funds must accommodate daily redemptions, which could be highly problematic for this strategy in a time of crisis.
If these funds become popular, will the liquidity premia disappear? To some degree, it might seem this is virtual certainty. As the funds grow in size, trading volume will increase for the securities they hold. They could then be forced to sell those holdings and buy others that they previously found unattractive.
Competition could also further erode the liquidity premia.
That said, Ibbotson’s liquidity premia measurements are impressive. Advisors will need to carefully assess whether these results will persist as funds like Ibbotson’s grow in size.
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