Morningstar Advisor - June/July 2009 - 25

liquid quartiles. The less-liquid stocks are not necessarily more risky. Measured by the standard deviation, risk seems to increase with liquidity. Exhibit 1 Quartile Geometric Mean (%) Arithmetic Mean (%) Standard Deviation (%) into the most-liquid quartile only grows to $12.68 over the period. These large differences in terminal wealth reflect investments at different share turnover rates but include most types of companies in each liquidity quartile. Liquidity as an Investment Style The premiums in the equity market are as follows: Equity Risk Premium 1—Illiquid 2 3 4—Liquid 15.46 13.57 11.66 7.11 17.23 15.44 14.14 10.73 19.81 20.08 22.91 27.32 Annualized returns (%). Data from 1972–2008. Exhibit 2 shows the same four quartiles of liquidity, but they are presented as indexes of cumulative wealth. The quartiles consist of equally weighted portfolios with all dividends reinvested. The least-liquid quartile of stocks is at the top of the graph; $1 invested at the end of 1971 grows to $204.47 by the end of 2008. One dollar invested in the second-least-liquid quartile grows to $110.86 over the period. One dollar invested in the third-least-liquid quartile (the second-mostliquid quartile) grows to $59.28 over the period. One dollar invested at year-end 1971 Similar to small versus large or value versus growth, illiquidity versus liquidity can be viewed as an investment style. Returns are on average higher for small, value, or illiquid stocks. In this way, liquidity can be thought of as another risk factor, with a risk premium. There are years in which each style outperforms, and years of underperformance. But each style has a long-run positive payoff for investing in it. Returns on stocks typically are greater than the returns on riskless (or default-free) bonds. This extra expected return is called the equity risk premium. The styles of investing can also add or detract from the investor’s return. In fact, for equity mutual funds, styles explain about half of the cross-sectional variation in equity mutual funds, with stock selection, market-timing, and fees explaining the other half. Styles seem to explain more of the variation in mutual fund portfolio returns than do industry sectors.2 The excess return of stocks relative to risk-free (default-free) government bonds. This premium can be measured over various bond horizons, and the bonds may themselves contain a horizon premium. Size Premium The excess return on small stocks versus the return on larger stocks. Value Premium The excess return on value stocks versus growth stocks. Illiquidity Premium The excess return on less-liquid stocks versus more-liquid stocks. Liquidity Versus Size It is natural to think that liquidity and size would be related. The total number of a company’s shares that are traded in a given period (say a year) are the number of shares outstanding times the turnover rate. Turnover is a measure of liquidity, adjusted for the number of shares outstanding. Exhibit 3 Size Liquidity 1—Low 2 3 Low Minus 4—High High Liquidity Exhibit 2: The Less Liquid the Better A basket of illiquid stocks outperforms more-liquid baskets of stocks. $1,000 Yearend Liquidity 1—Small 2 3 4—Large 17.35 15.99 12.42 4.09 16.24 14.10 10.55 4.66 14.58 13.88 11.98 7.89 11.89 11.01 10.78 8.47 4.98 1.65 –4.38 13.27 11.57 6.69 3.42 $204.47 1 Low 100 110.86 59.28 2 3 Small 5.46 Minus Large 10 12.68 4 High Compound annual returns (%). Data from 1972–2008. 1 1971 1983 1995 2008 Exhibit 3 breaks the universe of stocks into four turnover quartiles and four size-capitalization quartiles, each independently sorted. The numbers in the table are the compound annual (geometric mean) rate of returns for each category. Note that small stocks tend MorningstarAdvisor.com 25
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Morningstar Advisor - June/July 2009

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