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

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2009

Morningstar Advisr - June/July 2009
Contents
New on MorningstarAdvisor.com
Letter from the Editor
Contributors
Is SRI a Relevant Investment Strategy?
A Head for Numbers
Building a Business on SRI
Investment Briefs
The Liquidity Premium
Navigating the SRI Patchwork
Profit and Progress
How the Fed Contributes to Crises
Holding Steady
Appleseed Adds Value to SRI Formula
Four Picks for the Present
Long-Term Investors Can Find Value among Industrials
Higher Yields, Hold the Risk
Bargains in U.S. Industrials
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
Talkin’ ‘bout a Revolution
Morningstar Advisor - June/July 2009 - 47
Morningstar Advisor - June/July 2009 - Morningstar Advisr - June/July 2009
Morningstar Advisor - June/July 2009 - Cover2
Morningstar Advisor - June/July 2009 - Contents
Morningstar Advisor - June/July 2009 - 2
Morningstar Advisor - June/July 2009 - 3
Morningstar Advisor - June/July 2009 - New on MorningstarAdvisor.com
Morningstar Advisor - June/July 2009 - 5
Morningstar Advisor - June/July 2009 - 6
Morningstar Advisor - June/July 2009 - Letter from the Editor
Morningstar Advisor - June/July 2009 - Contributors
Morningstar Advisor - June/July 2009 - 9
Morningstar Advisor - June/July 2009 - Is SRI a Relevant Investment Strategy?
Morningstar Advisor - June/July 2009 - 11
Morningstar Advisor - June/July 2009 - A Head for Numbers
Morningstar Advisor - June/July 2009 - 13
Morningstar Advisor - June/July 2009 - 14
Morningstar Advisor - June/July 2009 - Building a Business on SRI
Morningstar Advisor - June/July 2009 - 16
Morningstar Advisor - June/July 2009 - 17
Morningstar Advisor - June/July 2009 - Investment Briefs
Morningstar Advisor - June/July 2009 - 19
Morningstar Advisor - June/July 2009 - 20
Morningstar Advisor - June/July 2009 - 21
Morningstar Advisor - June/July 2009 - 22
Morningstar Advisor - June/July 2009 - The Liquidity Premium
Morningstar Advisor - June/July 2009 - 24
Morningstar Advisor - June/July 2009 - 25
Morningstar Advisor - June/July 2009 - 26
Morningstar Advisor - June/July 2009 - 27
Morningstar Advisor - June/July 2009 - 28
Morningstar Advisor - June/July 2009 - 29
Morningstar Advisor - June/July 2009 - Navigating the SRI Patchwork
Morningstar Advisor - June/July 2009 - 31
Morningstar Advisor - June/July 2009 - 32
Morningstar Advisor - June/July 2009 - 33
Morningstar Advisor - June/July 2009 - 34
Morningstar Advisor - June/July 2009 - Profit and Progress
Morningstar Advisor - June/July 2009 - 36
Morningstar Advisor - June/July 2009 - 37
Morningstar Advisor - June/July 2009 - 38
Morningstar Advisor - June/July 2009 - 39
Morningstar Advisor - June/July 2009 - How the Fed Contributes to Crises
Morningstar Advisor - June/July 2009 - 41
Morningstar Advisor - June/July 2009 - 42
Morningstar Advisor - June/July 2009 - 43
Morningstar Advisor - June/July 2009 - 44
Morningstar Advisor - June/July 2009 - 45
Morningstar Advisor - June/July 2009 - 46
Morningstar Advisor - June/July 2009 - 47
Morningstar Advisor - June/July 2009 - Holding Steady
Morningstar Advisor - June/July 2009 - 49
Morningstar Advisor - June/July 2009 - 50
Morningstar Advisor - June/July 2009 - 51
Morningstar Advisor - June/July 2009 - Appleseed Adds Value to SRI Formula
Morningstar Advisor - June/July 2009 - 53
Morningstar Advisor - June/July 2009 - 54
Morningstar Advisor - June/July 2009 - 55
Morningstar Advisor - June/July 2009 - Four Picks for the Present
Morningstar Advisor - June/July 2009 - 57
Morningstar Advisor - June/July 2009 - Long-Term Investors Can Find Value among Industrials
Morningstar Advisor - June/July 2009 - 59
Morningstar Advisor - June/July 2009 - 60
Morningstar Advisor - June/July 2009 - 61
Morningstar Advisor - June/July 2009 - Higher Yields, Hold the Risk
Morningstar Advisor - June/July 2009 - 63
Morningstar Advisor - June/July 2009 - Bargains in U.S. Industrials
Morningstar Advisor - June/July 2009 - 65
Morningstar Advisor - June/July 2009 - Mutual Fund Analyst Picks
Morningstar Advisor - June/July 2009 - 67
Morningstar Advisor - June/July 2009 - 68
Morningstar Advisor - June/July 2009 - 69
Morningstar Advisor - June/July 2009 - 50 Most Popular Equity ETFs
Morningstar Advisor - June/July 2009 - 71
Morningstar Advisor - June/July 2009 - Undervalued Stocks
Morningstar Advisor - June/July 2009 - 73
Morningstar Advisor - June/July 2009 - 74
Morningstar Advisor - June/July 2009 - 75
Morningstar Advisor - June/July 2009 - Most Popular Variable Annuities
Morningstar Advisor - June/July 2009 - 77
Morningstar Advisor - June/July 2009 - 78
Morningstar Advisor - June/July 2009 - New at Morningstar
Morningstar Advisor - June/July 2009 - Talkin’ ‘bout a Revolution
Morningstar Advisor - June/July 2009 - Cover3
Morningstar Advisor - June/July 2009 - Cover4
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