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Getting a Boost From Less-Liquid Stocks

Buying the overlooked, somewhat less-liquid parts of the stock market can bring higher returns for investors, says Yale professor and Zebra Capital Management partner Roger Ibbotson.

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Morningstar Ibbotson Conference, and I recently had the opportunity to sit down with Roger Ibbotson. He is the founder of Ibbotson Associates. He is also a professor at the Yale School of Management and a partner at Zebra Capital Management.

Christine Benz: Roger, you mentioned your Zebra Capital investment and the funds that you run there. One big focus for you is looking at the universe of illiquid stocks. You have mentioned that that's maybe another dimension of our Morningstar Style Box. These are companies that trade less frequently than others... I know you found that there is ... a level of outperformance from those illiquid companies.

I'd like you to opine about the growth of passively managed products, ETFs, and how you think that will impact your search for illiquid companies? Will it make it easier for you to identify illiquid companies and invest in them, given that so many investors are focusing on very liquid investments via these passively managed funds?

Roger Ibbotson: First, let me say that we're talking in relative terms. There is always a most liquid part of the stock market, and there is a somewhat less liquid. But actually all the parts of the publicly traded market are really liquid for most purposes. So, it's really getting away from the exciting, hot-traded stocks that you might hear on the news all the time, and buying the other overlooked parts of the stock market, the less-popular parts of the stock market. ... In fact, those are where you will get the higher returns.

And so we actually implement this as a subadviser on mutual funds, for separately managed accounts, and we do it also on hedge funds. There are all sorts of possibilities, and you talked about alternatives before. Well, frankly, ... I wouldn't recommend going into private equity for my alternative. I think if you, in fact, instead invested in less liquid stocks, and actually we have hedge funds where we short the most liquid stocks, you end up with a liquid portfolio. That's the difference here. A private equity portfolio might tie up your money for five or 10 years, whereas you can capture a lot of these liquidity premiums and still have monthly or even daily, at times, liquidity. So, I don't think you should go that far. In fact, managing liquidity has all kinds of benefits, and it doesn't mean giving up a lot of liquidity. It means getting the appropriate amount of liquidity in your portfolio.

Benz: So you don't have to be in private equity; you can actually just be in stocks with a little less liquid that are publicly traded?

Ibbotson: Yes, and these publicly traded stocks, they trade every day. They trade every hour, really. They trade pretty continuously. And contrast that with private equity where ... you might actually tie up your money for over five years, you typically would. So, yes, you'll capture those liquidity premiums in private equity, but it's a costly way to do this, and so if you appropriately manage it, I think you can get a lot of bang for the buck here.

Benz: Your research has shown that that you can find some of those less liquid names not just in the realm of micro caps, you can actually find them and find that level of outperformance even within the realm of mid-caps and larger caps?

Ibbotson: Probably you don’t quite find it as much in the mega caps, but you definitely find it across the spectrum. You definitely find it on the large caps, mid-caps, small caps, micro caps. You find big differences in how they are valued, and we can even observe it as trading volume goes up in a stock, we can just see these valuations soar up. And some of that ... that's some of the ways we actually get returns by, in fact, as the trading volume goes up, the valuations go up, and then we can actually realize the returns on these stocks.

So, ... when you are think of what really helps you value a company, the two big things are risk and liquidity. And so, if a stock is very risky, it tends to be valued less, for say a given set of cash flows, but if a stock is less liquid, it tends to be valued less. These are the two big drivers. And really it's sort of in its infancy that we try to manage money to actually take advantage of the two big drivers of returns.