In 1992, William F. Sharpe defined four criteria that characterize a benchmark investment style: (1) “identifiable before the fact,” (2) “not easily beaten,” (3) “a viable alternative,” and (4) “low in cost.” We propose that equity liquidity meets these criteria and should be given equal standing with the currently accepted styles of size, value/growth, and momentum.
Extensive academic literature has confirmed that less liquid stocks outperform more liquid stocks under various measures of liquidity. Despite this significant and multifaceted body of evidence, liquidity has rarely been treated as a control in cross-sectional studies of stock returns.
In our study, we used stock turnover, which is a well-established measure of liquidity that is negatively correlated with long-term returns in the U.S. equity market. We examined stock-level liquidity in a top 3,500 market-capitalization universe of U.S. equities over 1971–2011 and subjected it to the four style tests of Sharpe. Our empirical findings, which extend and amplify the existing literature, are that liquidity clearly meets all four criteria.
First, the previous year’s stock turnover is “identifiable before the fact.” Other liquidity measures could have met that criteria as well, but we chose turnover because it is simple and easy to measure and has a significant impact on returns.
Using each investment style, we constructed top quartile portfolios, all of which outperformed the equally weighted market portfolio. The returns of the low-liquidity quartile portfolio were comparable to those of the other styles, beating size and momentum but trailing value. We consider all four styles to be “not easily beaten.”
We constructed double-sorted independent portfolios, comparing liquidity with size, value, and momentum in four-by-four matrices. The impact of liquidity was additive to each of the other styles. Thus, we determined that liquidity is a distinct and “viable alternative” to size, value, and momentum.
We also constructed a liquidity factor by subtracting the Quartile 4 high-liquidity return series from the Quartile 1 low-liquidity return series. This factor added significant alpha to all the Fama–French factors when expressed either as a factor or as a low-liquidity long portfolio. The existence of the significant positive alpha is further evidence that investors ought to include liquidity with the other styles to form efficient portfolios.
Finally, we demonstrated that less liquid portfolios could be formed “at low cost.” Our portfolios were formed only once a year, and 63% of the stocks stayed in the same quartile in consecutive years. Some 77% of the stocks in the high-performing low-liquidity quartile stayed in that quartile. Thus, the liquidity portfolios themselves exhibit low turnover, which can keep their costs low.
Liquidity has perhaps the most straightforward explanation as to why it deserves to be a style. Investors clearly want more liquidity and are willing to pay for it in all asset classes, including stocks. Less liquidity comes with costs: It takes longer to trade less liquid stocks, and the transaction costs tend to be higher. In equilibrium, these costs must be compensated by less liquid stocks earning higher gross returns. The liquidity style rewards the investor who has longer horizons and is willing to trade less frequently.
However, less liquid does not necessarily mean higher risk. In all cases in our study, the less liquid portfolios were substantially less volatile than the more liquid portfolios.