Equity Investing Based on Liquidity

Is the variation of individual stock returns with liquidity a sound investment foundation? In the April 2011 version of their paper entitled “Liquidity as an Investment Style”, Roger Ibbotson, Zhiwu Chen and Wendy Hu examine the viability and distinctiveness of a liquidity investment style and investigate the portfolio-level performance of liquidity in combination with size, value and momentum investment styles. They define liquidity as annual turnover, number of shares traded divided by number of shares outstanding, a metric fairly independent of market capitalization. They hypothesize that stocks with relatively low (high) turnover tend to be near the bottom (top) of their ranges of expectation. Their liquidity style thus overweights (underweights) stocks with lower (higher) annual turnover. Using monthly data for the 3,500 U.S. stocks with the largest market capitalizations (with some screening for price, market capitalization, stock type and data availability) over the period 1972-2010, they find that: (more…)