Morningstar Advisor - June/July 2009 - 26

Gray Matters to outperform large stocks in general, but not for the most-liquid stocks. In fact, for the most-liquid stocks shown in column four, the pattern is reversed. The poorest-performing category is the highly liquid stocks that are the smallest in size; that is, that upper-right quartile with a return of only 4.09% per year. The best-performing category is column one, which represents the least-liquid stocks. The worst-performing category is column four, the most-liquid stocks. There is a clear pattern of decreasing returns as the liquidity of the stocks increase. The best-performing category is the small, illiquid stocks, with a 17.35% return. As shown in the last column (low minus high liquidity), the impact of liquidity is strongest for the smallest companies and weakest for the largest companies. However, the impact of liquidity is strong and consistent across all categories. Liquidity appears to be a much better predictor of returns than does size. Note the mixed results for size shown in the bottom small-minus-large row. Liquidity Versus Value/Growth are rebalanced once per year with the earnings lagged by two months to reflect delays in compiling the accounting earnings. Exhibit 4 Liquidity Value/Growth 1—Low 2 3 Low Minus 4—High High Liquidity 1—Value 2 3 19.91 17.25 16.18 11.07 15.31 14.37 12.79 11.01 13.42 11.53 9.78 6.97 9.68 6.40 1.82 9.26 8.83 4.30 7.02 8.95 4—Growth 10.77 10.27 6.51 Value 9.14 Minus Growth In Exhibit 5, the returns for each market are shown for the first and fourth quartiles, showing the most-liquid and least-liquid stocks, ranked by turnover. The universe is the largest-capitalization stocks in each market, with 3,500 stocks in the United States, 500 stocks in the United Kingdom, 1,000 stocks in Japan, and 1,000 stocks in the E.M.U. In each market, there is a substantially higher return for the less-liquid stocks compared with the most-liquid stocks. Conclusion Compound annual returns (%). Data from 1972–2008. Value tends to outperform growth over time. We’ve shown that less-liquid stocks outperform more-liquid stocks. In this section, we examine how liquidity interacts with value and growth. We ranked the stocks by turnover rates and separated them into quartiles. Similarly, we ranked the stocks by the earnings/ price ratios and separated them into quartiles. The high earnings/price companies were considered value companies, and the low earnings/price companies were growth companies. The inverse, of course, is the P/E ratio, with the growth companies having high P/E ratios, and the value companies having low P/E ratios. The earnings used were the trailing reported earnings. The earnings data is from Compustat, owned by Standard & Poors. The portfolios Exhibit 4 presents the quartile results for the different levels of liquidity and value/growth. Note that both liquidity and value/growth have a strong impact on stock market returns across all categories. The results appear to be additive. There is an excess return for investing in either low-liquidity or value stocks, and the best return of all was earned by investing in the upper-left category: high-value lowliquidity stocks, which have a realized return of 19.91%. The worst category is the lowerright corner, high-liquidity growth stocks, which have a return of 1.82%. International Liquidity Premiums Liquidity seems to have an impact on realized and expected returns across all types of securities and across all locations. Liquidity is valuable in any security, and the market seems to be willing to pay a high price for it. Correspondingly, the market accepts a lower return for liquidity. Liquidity seems to be an investment style that is different from size or value. This result seems to hold up in almost any equity market subset and in any location. K Zhiwu Chen is partner and director of research at Zebra Capital and professor of finance at Yale School of Management. Roger G. Ibbotson is chairman and CIO of Zebra Capital. He is also professor in practice at Yale School of Management and the founder, former chairman, and current advisor to Ibbotson Associates Inc., a Morningstar, Inc. company. This article uses research developed by Zebra Capital. Wendy Hu of Zebra Capital helped to develop the empirical results. Footnotes 1 See Ibbotson, Roger, Siegel, Laurence B., and Diermeier, Jeffrey “The Demand for Capital Market Returns,” Financial Analysts Journal, January/February 1984. 2 See James X. Xiong, Roger G. Ibbotson, Thomas Idzorek, and Peng Chen, “The Importance of Asset Allocation: Why Does Your Return Differ From Mine?” Ibbotson Associates Working Paper, January 2009. We separated the returns from 1996 through 2008 into quartiles for the U.S., U.K., European Monetary Union, and Japanese markets. The international returns data and the trading volume data are from International Data Corp., and the earnings data is from Worldscope. Exhibit 5 Country/Num. of Stocks Liquidity Low High Benchmark Return U.S. (3,500) U.K. (500) E.M.U. (1,000) Japan (1,000) 11.04 4.00 12.31 1.40 2.35 –1.35 2.82 –5.44 S&P 500 MSCI U.K. MSCI JP. 4.78 0.76 –3.22 MSCI E.M.U. 6.52 Compound annual returns (%). Data from 1996–2008. Source: Zhiwu Chen and Roger G. Ibbotson, Zebra Capital Management, LLC. All rights reserved. www.zebracapm.com 26 Morningstar Advisor June/July 2009
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Morningstar Advisor - June/July 2009

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