Morningstar Advisor - April/May 2013 - (Page 64)

Gray Matters Liquidity Signals By James X. Xiong, Rodney N. Sullivan, and Peng Wang Incorporating market-liquidity levels in a dynamic asset-allocation policy improves portfolios. A longer version of this article will be published in the 2013 summer issue of the Journal of Portfolio Management. At the micro-level, liquidity relates to the speed and ease with which an investor can trade an asset. Amihud and Mendelson (1986) used the bid-ask spread as a measure of liquidity to test the relationship between security returns and liquidity. They found evidence that investors demanded a premium for illiquid securities. Datar, Naik, and Radcliffe (1998) used the turnover rate (number of shares 64 Morningstar Advisor April/May 2013 traded as a fraction of the number of shares outstanding) as a proxy for liquidity and found that firm-level stock returns are strongly negatively related to their turnover rates. Using autocorrelation in returns as a proxy for illiquidity, Khandani and Lo (2011) showed that illiquidity premiums are generally positive and significant, ranging from 2.74% to 9.91% per year among hedge funds and fixed-income mutual funds. These results all support the notion of an illiquidity premium: Lower levels of liquidity relate to higher average returns. At the macro-level, liquidity has also been shown to be an important variable in the pricing of assets. Stock prices relate crosssectionally to fluctuations in aggregate liquidity [Amihud (2002), Pastor and Stambaugh (2003), Kamara, Lou, and Sadka (2008)]. This research further shows that common measures of liquidity risk move together and that liquidity influences the market return, not just the return of a single asset, cross-sectionally.

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013