Ibbotson: Less liquidity doesn't mean more risk

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Roger G. Ibbotson

Academic research has long influenced portfolio management, including the development of modern portfolio theory, optimizing the risk and return relationship in investing.

“I will say academics in most fields don't influence the world as much as finance does,” said Roger G. Ibbotson, professor emeritus in the practice of finance, Yale University School of Management, and chairman and chief investment officer, Zebra Capital Management LLC. Milford, Conn.

“Because when academics (in finance) discover things, we are basically teaching people how to make money,” Mr. Ibbotson said in an interview. “I would say almost no other field of academics has influenced the real world as much as the finance field, at least in the short run. Obviously, you make big discoveries in physics or something, they ultimately change society. I think in academics (in finance) the impact is much faster because we're actually studying money and real returns and things like that. The impact is quite direct.”

That is why portfolio managers are interested in keeping their eyes open to the latest in academic research, Mr. Ibbotson said.

“The discoveries often have big impacts on how they will manage the money,” Mr. Ibbotson said.

Mr. Ibbotson has long been researching the concept of liquidity. His more recent research has identified liquidity as a factor for predicting stock returns. Mr. Ibbotson began applying it to portfolio management at Zebra Capital in the last year or two.

The “discovery will have a big impact,” Mr. Ibbotson said. “People used to think of liquidity as a free good,” without a cost. If you ask investors, “Do you want more or less liquidity?” Investors “want more liquidity.”

But more highly liquid investments lead to lower returns than less liquid investments, Mr. Ibbotson said.

Low liquidity “is not more risky. In fact, it's less risky.”

In March, Mr. Ibbotson and three colleagues were named winners of the annual CFA Institute's Graham and Dodd Award for their Financial Analysts Journal article “Liquidity as an Investment Style.”

The other co-authors are Zhiwu Chen, professor of finance at the Yale School of Management; Daniel Y.-J. Kim, research director at Zebra; and Wendy Y. Hu, senior quantitative researcher at Permal Asset Management.

In their paper, they wrote, “equity liquidity is a missing investment style that should be given equal standing with the currently accepted styles of size,” value/growth and momentum.

“When assembled into portfolio, these styles define a set of beta that can be beaten only if the portfolios provide a positive alpha.”

Despite its significance, “liquidity is rarely included” as a factor, according to a survey of the last 25 years of literature on the determinants of expected stock returns, the authors wrote in the paper.

“It is surprising how much (investors) will pay extra to get extra liquidity” in the form of paying more for a stock, Mr. Ibbotson said. But with less liquid stocks, “you actually don't have to give up very much liquidity ... but you actually get substantially extra returns.”

This article originally appeared in the April 14, 2014 print issue as, "Ibbotson: Less liquidity doesn't mean more risk".