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Liquidity's Tremendous Effect on Returns

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Ibbotson Conference with Roger Ibbotson. Roger, thanks for being here.

Roger Ibbotson: Great to be here.

Benz: Roger is chairman and a chief investment officer at Zebra Capital. He is also a professor at the Yale School of Management and was the founder of Ibbotson Associates.

So, Roger, this morning you presented some interesting data about liquidity, and how you see a connection in your research with liquidity and higher returns. Can you discuss what you see there, please?

Ibbotson: It starts out with, everybody's studied, for the last 60 years, that there's a risk/return relationship. What they've ignored, for the most part, something almost as important, is there's a liquidity/return relationship. Essentially, what that means is, the more liquid an asset is, the more you have to pay for it. If you buy a less-liquid asset, you get to buy it at a discount. And that means you get higher returns.

And this applies to all kinds of assets. That applies to, say, very illiquid things, like real estate or private equity. But it also applies to public markets. There's gradations of liquidity. And the most-liquid stocks you have to pay the full price for. The less-liquid stocks you get to buy at discounts.

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Benz: So, you have looked at Morningstar's Investment Style Box, which shows small, mid, large, as well as investment style, value to growth. You think that the liquidity should actually be an additional lens on the Style Box that can help investors identify where those pockets of illiquidity are.

Ibbotson: That's true. In the Style Box, you have large versus small and you have value versus growth. Well, less-liquid versus more-liquid is just as important as those. I'm not sure how they're going to put another dimension to the Style Box, but I really believe they're missing a big dimension here. It has a tremendous effect on returns over time.

Benz: So, if lower liquidity is correlated with higher returns, and I'm an individual investor managing my portfolio, how should I think about incorporating that data into my own portfolio management?

Ibbotson: Well, as an individual, it's sort of a little more difficult, because what I'm really saying is, say I showed some charts that show that value beats growth. Those are sort of the companies that have good earnings and so forth, but they have very weak stories about what their futures might be.

Well, it's the same sort of thing with liquidity. You essentially have to be buying the companies that are not in the news. The companies that are in the news, the brand names, those are the ones that you have to pay the full price for. It's a little harder to do this, but the companies you've never heard of are actually the companies that are going to have the higher returns.

Benz: So this data carries over even beyond, say, the small and micro-cap area. You see this liquidity data and lower liquidity leading to better returns, even in the large-cap space.

Ibbotson: Across the whole spectrum. In the large-cap space, there's definitely an incremental extra return by buying the less-brand-name stocks. It's, of course, even more true in the mid- to small-cap space. There's extra returns buying the less-traded stocks. But essentially, people want liquidity. Somebody has to buy the less-liquid things, and that's why the bargains are in the less-liquid stocks.

Benz: Good information, Roger. Good research. Thanks for joining us.