Morningstar Advisor - October/November 2012 - (Page 62)

Gray Matters Less-Liquid Holdings Mean More-Solid Results By Thomas M. Idzorek, James X. Xiong, and Roger G. Ibbotson The liquidity investment style is present in mutual funds and leads to dramatic differences in performance. It is well known that less-liquid investments tend to outperform more-liquid investments. The same holds true within the universe of publicly traded stocks. The generally accepted rationale for a liquidity premium is that all else equal, investors prefer greater liquidity; thus, in order to induce investors to hold less-liquid assets, they must have the expectation (but not the guarantee) of a return premium. Recent literature indicates that the liquidity investment style—the process of investing in less-liquid stocks within the liquid universe of publicly traded stocks—produces riskadjusted returns that rival or exceed those of the three best-known market anomalies: size, value, and momentum (see Carhart, 1997). For example, Amihud and Mendelson (1986) used the quoted bid-ask spread as a measure of liquidity and tested the relationship between stock returns and liquidity during the period of 1961–1980. They found evidence consistent with the notion of a liquidity premium. Datar, Naik, and Radcliffe (1998) used the turnover rate (number of shares traded as a fraction of the number of shares outstanding) as a proxy for liquidity and found that stock returns were strongly negatively related to their turnover rates, confirming the notion that less liquid stocks provided higher average returns. Overall, the results supported the relationship between less liquidity and higher stock returns. 62 Morningstar Advisor October/November 2012

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012