by Roger Ibbotson

mba.yale.edu/faculty/pdf/ibbotson_liquidity_as_an_investment_style.pdf .

Charles Rotblut, CFA

Charles Rotblut (CR): Id 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 valuationparticularly for longer-term investors. If theyre 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 youre 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. Youre 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 dont 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, youre basically buying the types of stocks that other people arent so interested in. In fact, thats how you get your bargains in the market: You buy the types of securities that other people do not want.

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, dont 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, youre going to get the result that stocks that are less liquid have lower valuations and higher returns.

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CR: For calculating turnover, youre 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 excitingthe 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 dont 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 isnt 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 dont know if the market itself is a style, but thats 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 youre talking about a value stock or a growth stock, the less liquid version tends to have the higher returns.

[Editors 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.

RI: Yes, we have a table showing quartiles of size. [Editors 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 youll also see a spread that is statistically significant even in the large caps, which would be row 4.