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Ibbotson: Capture Excess Returns on Illiquidity

Nadia Papagiannis, CFA

Nadia Papagiannis: Hello. My name is Nadia Papagiannis. I'm an alternative investment strategist here at Morningstar. Today I have with me Roger Ibbotson, who is a professor of finance at the Yale School of Management, CIO of Zebra Capital, and of course, the founder of Ibbotson Associates, a Morningstar company.

Thanks for joining us today, Roger.

Roger Ibbotson: It's great to be here. Thank you for inviting me.

Papagiannis: Roger, recently you've done a lot of research on liquidity and the illiquidity premium, and in fact, you've incorporated that into an investment strategy. Can you define for us what liquidity is and what an illiquidity premium is?

Ibbotson: Well, we think of a liquidity premium is a fact that you can get higher returns by investing in any kind of asset that's somewhat less liquid. If you buy an asset in its most liquid form, you're just going to have to pay the full price for it, but if you buy any kind of an asset in a less liquid form, you're going to get it at a discount, and that means you're going to get higher returns. That's the liquidity premium.

Papagiannis: So, can we consider this as a style? Is this a style of investing, liquidity?

Ibbotson: You certainly can think of this as a style because it's separate enough from size or value that it could be a style. In fact, it's just as strong of an impact as any of the existing styles. So, it certainly could be thought of as a style, I guess. I don't know how it's going to fit into the nine-style boxes at Morningstar because it brings a another dimension into this, but it's just as strong of an impact as any of the existing styles.

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Papagiannis: Can you consider the premium that we capture from liquidity as an alpha that we should pay management fees on or is it just a beta that we should pay very low expense ratio for an ETF or something like that?

Ibbotson: It's been said, I wish I knew who to quote, but it's been said that when things are first discovered, they are alphas, and then after everybody knows them for a long time, they become betas. So, I think at this stage, I guess, I would frankly call it an alpha because basically we are the only ones doing this right now, at least, in the public equity space. So I would think of it as more of an alpha. But as it becomes more known and more understood by the press, the market, people will say, well, I want to manage my liquidity, too, and it becomes more of a beta over time. So it potentially become a style. But before it's a style, it's just a way of getting some extra returns.

Papagiannis: It's a good thing to invent the style.

Ibbotson: Well, we get some extra returns, and after a while people say, well, really it's something that other people can do, too, and we can all capture this and it becomes more like a beta over time.

Papagiannis: What would be a good investment strategy using your research on liquidity premium?

Ibbotson: Well, generally, of course, these other premiums exist, so we actually would want to buy the fundamentals. You want to buy the fundamentals of a company, but you want them to be less liquid. So a strategy would be to actually pick up some of this value premium at the same time you're picking up the liquidity premium. You don't want to just have it independent of everything else; you have to pick it up in conjunction with something else, and it's very reasonable to buy fundamentally strong companies that are less liquid and this will give you this excess return.

Papagiannis: So you could sort a bunch of stocks, and you could sort them based on their value bias and you could sort them based on their turnover or their low turnover, and that would give you the liquidity bias. And so, you would go along those stocks and could this be a long short strategy as well.

Ibbotson: It actually works in any geographic market in any form, long-long or long-short. Essentially you want to take long positions in fundamentally strong companies that are less liquid. You would want to take short positions in fundamentally weak companies that are extremely liquid. Basically, of course, those are the most exciting companies. You would want to short those exciting glamour companies and we would – we do, of course, on our hedge fund variance of these kind of things – short the most exciting companies, but take long positions in the companies that there is a lot less interest in, that are essentially out of the news, that are overlooked, forgotten stocks, but are still fundamentally strong. So the best strategy is to buy the fundamentals, but buy them where there is less demand, where there is less liquidity.

Papagiannis: So how has this equity liquidity strategy held up during times of liquidity crisis?

Ibbotson: Well, actually it holds up amazingly well. The kinds of things you are talking about in a liquidity crisis, I think, for the most part, do not involve the equity market. There are some spillover effects to the equity market. But mostly you are talking about things like – the worst market was the credit default swaps, which almost completely dried up, and they had all this counterparty risks, different problems.

The whole derivatives market is very prone to being very active within the volume drying up and going through these cycles. Even the fixed income market, especially when get into the more distressed parts of the fixed income market, you get these cycles over time where there is a big change in the liquidity, but the liquidity can dry up.

We don't really see this in public equity markets to any great extent. We only see it to very limited extents. For example, on the financial crisis, there was really strong liquidity across the board in equity markets throughout the financial crisis. So, it's not that you couldn't have it dry up to some extent. But the only examples that I can even think of mostly have been a few days or at most a few weeks of sort of limited drying up of liquidity in equity markets.

I mean I can think of assorted ones, but for example, the most severe one recently was the 9/11 in 2001. And basically liquidity dried up because a lot of the offices had to move out of the Wall Street area in the crisis, and so liquidity was down for a month or so. But basically it comes back pretty fast, and the more recent crisis, stock market liquidity was hardly effected at all by it.

So, generally, the impacts are, if they are there, they are quick and they recover quickly, and you don't have these kind of problems in the equity markets.

Papagiannis: Well, it sounds like a great investment strategy. Thanks for explaining it to us today.

Ibbotson: Thank you. It was great to be here.