Equity Market Liquidity as an Asset Allocation Signal

Posted in Strategic Allocation

 

Is equity market liquidity useful as an asset allocation signal? In their November 2012 paper entitled “Liquidity-Driven Dynamic Asset Allocation”, James Xiong, Rodney Sullivan and Peng Wang examine the performance of a dynamic stocks-bonds allocation strategy with weightings based on equity market liquidity. For liquidity measurement, they focus on monthly changes in Amihud illiquidity (aggregating individual responses of stock prices to trading volume), calculated daily for a broad sample of U.S. stocks, averaged over the past six months and detrended. They also consider a similarly calculated monthly change in aggregate stock market turnover as an alternative liquidity measurement. For each measurement, they define high and low expected liquidity premium conditions based on a fixed liquidity threshold. They then use this threshold to define a dynamic asset allocation (DAA) strategy for a simple portfolio consisting of stocks (four U.S. style indexes, a REIT index and MSCI EAFE as separate proxies) and bonds (proxied by the Barclays Capital 1-3 Year Government/Credit Index). The benchmark strategic asset allocation (SAA) is 50% stocks and 50% bonds, rebalanced monthly. The DAA strategy each month allocates 60% (30%) to stocks and 40% (70%) to bonds when the expected equity liquidity premium is high (low), with monthly trading friction 0.1% of the value of the portfolio turned over. Using liquidity calculation inputs since January 1963 and portfolio asset total monthly returns since December 1980, both through September 2010, they find that: (more…)

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