Liquidity as an Investment Style

31 Pages Posted: 12 Sep 2010 Last revised: 15 Sep 2010

Zhiwu Chen

Yale University - International Center for Finance; Zebra Capital Management, LLC

Roger G. Ibbotson

Yale School of Management; Zebra Capital Management, LLC

Wendy Hu

affiliation not provided to SSRN

Multiple version iconThere are 2 versions of this paper

Date Written: September 10, 2010

Abstract

We first show that liquidity, as measured by stock turnover or trading volume, is an economically significant investment style that is distinct from traditional investment styles such as size, value/growth, and momentum. We then introduce and examine the performance of several portfolio strategies, including a Volume Weighted Strategy, an Earnings Weighted Strategy, an Earnings-Based Liquidity Strategy, and a Market Cap-Based Liquidity Strategy. Our backtest research shows that the Earnings-Based Liquidity Strategy offers the highest return and the best risk-return trade-off, while the Volume Weighted Strategy does the worst. The superior performance of the liquidity strategies are due to equilibrium, macro, and micro reasons. In equilibrium, liquid stocks sell at a liquidity premium and illiquid stocks sell at a liquidity discount. Investing in less liquid stocks thus pays. Second, at the macro level, the growing level of financialization of assets in the world makes today’s less liquid securities increasingly more liquid over time. Finally, at the micro level, the strategy avoids, or invests less, in popular, heavily traded glamour stocks and favors out-of-favor stocks, both of which tend to revert to more normal trading volume over time.

Keywords: Liquidity, Stocks, Investment Style

JEL Classification: D40l, D46, G00, G10, G11, G12

Suggested Citation

Chen, Zhiwu and Ibbotson, Roger G. and Hu, Wendy, Liquidity as an Investment Style (September 10, 2010). Yale SOM Working Paper. Available at SSRN: https://ssrn.com/abstract=1675108 or http://dx.doi.org/10.2139/ssrn.1675108

Zhiwu Chen

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520-8200
United States
203-432-5948 (Phone)
203-432-6970 (Fax)

Zebra Capital Management, LLC ( email )

612 Wheelers Farms Road
Milford, CT 06461
United States

Roger G. Ibbotson (Contact Author)

Yale School of Management ( email )

165 Whitney Avenue
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-6021 (Phone)
203-432-6970 (Fax)

Zebra Capital Management, LLC ( email )

612 Wheelers Farms Road
Milford, CT 06461
United States

Wendy Hu

affiliation not provided to SSRN ( email )

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