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Rekenthaler Report

Less Risk, More Return

The curious tale of less-liquid stocks.

Mirror Universe
The premise of investing is that performance comes from assuming risk. No risk means no investment, as owning a riskless asset is merely saving. A little risk, a little return. More risk, more return.

That’s pretty much how things happen. Consider short-term government bonds. Being only modestly vulnerable to changes in interest rates, and (for developed countries in recent years) rarely failing to meet their obligations, they are the first step up the risk ladder. Their returns have been commensurately moderate. In most major financial markets, including the U.S., short governments have been outpaced by higher-risk bonds over the long haul, which in turn have been beaten by stocks. As it should be.

The same pattern should hold within the stock market. While the rule that extra return comes from extra risk was made to be broken--an individual lower-volatility stock might readily outperform its more-hazardous peers, and at various times even the overall market behaves contrarily--logic suggests that it will generally apply. If something safer consistently beats something that is more speculative, who will want to own the speculative? That security should decline in price to the point where it becomes a compelling value, so that it therefore posts suitable high future returns.

Thus, U.S. stock-market performance should look something like the picture below. The chart sorts stock returns for the period 1972-2013 by quartiles, with the lowest quartile posting a nominal annualized gain of 8.27% and the highest 15.51%. (Even subtracting 3.8 percentage points per year for the average inflation rate, that was one very fine 40-year stretch.) For each of these return quartiles, I assigned a standard deviation that gives all four groups the same Sharpe ratios. That is the look of an "efficient" market.

This is what actually happened.

To explain further… I cheated a bit. Those return quartiles weren’t created by ranking all stocks from best to worst performance, then sorting on those numbers. Rather, they were created by ranking all stocks by their liquidity, from a 2014 Journal of Portfolio Management article entitled "Dimensions of Popularity," by Roger Ibbotson and Tom Idzorek. (Liquidity, meaning the ability to trade the security, is calculated in this instance as the percentage of a stock’s shares that are traded each day. The higher that percentage, the higher the stock’s liquidity score.) The top-gaining quartile, that is the group that averaged 15.5% per year, consisted of those stocks that had the lowest liquidity. Conversely, the bottom quartile, which lagged far behind at 8.27%, held the most-tradeable stocks.

That stock returns were correlated with a lack of liquidity breaks no theory. All things being equal, one would prefer to trade a security with ease. Therefore, as a whole, investors will accept a lower rate of return in exchange for that favorable attribute. Granted, the magnitude of the liquidity effect is surprising--I would argue even shocking--but the direction is not.

However, there’s no good explanation for the slope of the line in the second graph, which shows the higher gains that came from less-liquid stocks being associated with lower risk. That picture shatters the first assumption of investing. Receiving strongly better returns, yet also comfortably lower volatility, is akin to dining on a free lunch, with dessert also on the house.

There is a partial answer to the puzzle. Liquidity is strongly associated with the value-stock premium, as stocks that don’t frequently trade tend to come from companies that sell at relatively low price multiples. Because value stocks have also posted higher historical returns than their competitors, with less risk than predicted by theory, the liquidity finding can to some extent be explained by the rationale for the value premium.

(Unfortunately, the rationale for the value premium isn’t very good, but we’ll set aside that inconvenient fact for this column.)

However, the value effect is not that strong. There’s something else going on with low-liquidity securities besides what value contributes.

And I don’t know that that additional thing is. With many assets, low liquidity artificially depresses the investment’s apparent risk level, as infrequent trading leads to “sticky” prices. Real estate, of course, is a prime example. Another is most of the municipal-bond market, which trades by appointment. But even the least liquid of stocks is repriced several times each day, by parties conducting arms’ length transactions. Yes, during a crisis selling pressure might temporarily cause strong stock-price swings, but for the most part, standard deviation would seem to be a fairly accurate method for measuring their relatively volatility.

So, I don’t know. The benefit from giving up liquidity in the stock market appears in part to come from the value premium, and in part from something else.

The bad news for mutual-fund investors: It's hard to find funds that invest mostly in the lowest-liquidity quartile of stocks. Those tend to be smaller companies, which are often not heavily owned by institutions. However, there are some major, successful funds that tilt toward less-liquid stocks, so that they should enjoy at least a part of that very large premium, should the premium persist. I've listed six such funds below. All six funds hold stocks that are relatively illiquid, by the standards of the fund industry, and all six funds receive the highest Morningstar Analyst Rating of Gold.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.