Investment Insights

Jeff Benjamin

When less liquidity means more

Stocks with lower trading volumes often outperform peers, research shows

Jun 13, 2010 @ 12:01 am

By Jeff Benjamin

One major takeaway from the recent financial crisis is the key role of liquidity. Without the presence of many willing buyers and sellers, we have seen how poorly markets function. When it comes to the market as a whole, therefore, the golden rule seems to be the more liquidity, the better.

But when it comes to particular investments, sometimes less liquidity is actually more.

It turns out that with stocks, as is the case with bonds and some alternative investments, investors pay a price for being able to buy and sell whenever they want. As a result, stocks that trade less frequently and are less liquid often outperform their more liquid peers.

Although it seems contrary to common sense that investing in low-liquidity stocks can lead to outsize returns, a recent study jointly produced by the Yale University School of Management and Zebra Capital Management LLC found just that. The researchers compared low-liquidity stocks with five broad-market indexes — global equities, U.S. equities, the United Kingdom, the European Union and Japan — and found that low liquidity won out across the board from pure risk performance characteristics.

During the 14-year period ended Dec. 31, on a back-tested basis, a global portfolio of lower-liquidity stocks produced a 13.1% average annual return, which compares with 7.9% for the MSCI World Index.


Further, the low-liquidity portfolio had a beta, or index correlation, over the period of 0.75, meaning that it is less correlated to the overall market than the benchmark is. It also had a Sharpe ratio, or risk-adjusted return, of 0.65, compared with 0.25 for the MSCI World Index (the higher the ratio, the better).

The results were similar across all five indexes.

In the case of the European Union, for example, the low-liquidity portfolio had an average annualized return of 17.7%, a beta of 0.68, and a Sharpe ratio of 0.95. That compares with the MSCI EMU Index, which had an 11.5% annualized return and a 0.45 Sharpe ratio.

“It has been an overlooked area of the equity markets, but the fact is, the liquidity premium exists in all parts of the market,” said Roger Ibbotson, founder, chairman and chief executive of Zebra Capital Management.

One of the reasons that less liquidity tends to benefit stock performance is that the lower trading volume generally applies in good times and bad, meaning that less liquid stocks are less susceptible to the market's wild rides.

“Basically, you buy the companies that are less exciting and out of the news, and you short those companies that are most exciting and are in the news,” Mr. Ibbotson said.

In practice, here is how it works. Cardinal Health Inc. (CAH) is a pharmaceutical and biotechnology distributor with a $12.5 billion market capitalization and relatively low average daily trading volume of 3.4 million shares.

On the other end of the spectrum is Fifth Third Bancorp (FITB), a financial stock that has attracted a lot of interest since the financial crisis.

Fifth Third has a $9.9 billion market cap and an average daily trading volume of 15.8 million shares, which is more than four times the volume of Cardinal Health. This year through May 31, shares of Fifth Third had gained 33.5%, while shares of Cardinal Health had increased 7.5%

Both stocks have outperformed the S&P 500, which declined 2.3% over that period, but the liquidity investing strategy suggests more upside potential for Cardinal and less for Fifth Third.

Mr. Ibbotson, the founder of Ibbotson Associates, a financial research firm that was acquired by Morningstar Inc. in 2006, manages $450 million in separate-account assets.

Since November, he has been building portfolios for clients based on low average daily trading volume of companies that meet other characteristics of being fundamentally sound businesses. Mr. Ibbotson is also subadvising two mutual funds launched this month that use liquidity as a primary screening tool.

The funds, American Beacon Zebra Large Cap Liquidity Return (AZLAX) and American Beacon Zebra Small Cap Liquidity Return (AZSAX), are the latest from American Beacon Advisors Inc., which has $45 billion under management.


Identifying less liquid stocks falls right into line with the philosophy that liquidity premiums are prevalent in the fixed-income area. For example, if two comparable bonds are issued, the less liquid version will pay a higher yield.

The liquidity premium is the impetus for alternatives such as private equity, venture capital and real estate, where investors typically will give up liquidity in exchange for higher returns.

This phenomenon is most ob-servable and measurable in the fixed-income market because yield is forward-looking in a bond. But in the equity area, the liquidity premium shows up only in the form of historical returns.

It is difficult to make an apples-to-apples comparison of how trading volume affects returns on stocks, because stocks rarely stack up evenly the way bonds do.

But the research suggests that lower trading volume is often equated to being out of favor. And if those discounted stocks also have strong fundamentals, they eventually will be recognized by the market.

Questions, observations, stock tips? E-mail Jeff Benjamin at


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