Liquidity-Driven Dynamic Asset Allocation

Abstract

We propose a model of portfolio selection that adjusts an investors’ portfolio allocation in accordance with changing market liquidity environments and market conditions. We found that market liquidity provides a useful “leading indicator” in dynamic asset allocation. Specifically, market liquidity risk premium cycles anticipate economic and market cycles. Investors can therefore act to avoid markets with low liquidity premiums, waiting to extract liquidity risk premiums when the likelihood of extracting a liquidity premium improves. The result, meaningfully enhanced portfolio performance through economic and market cycles, and is robust to transactions costs and alternate specifications.

Keywords: asset allocation, dynamic asset allocation, liquidity

JEL Classification: G1, G12