Can investors systematically earn a premium by holding relatively illiquid assets? In their December 2012 paper entitled “The Illiquidity Premium: International Evidence”, Yakov Amihud, Allaudeen Hameed, Wenjin Kang and Huiping Zhang examine the illiquidity premium in 26 developed and 19 emerging equity markets. They measure illiquidity as the average ratio of absolute daily stock return to trading volume (price impact per monetary volume traded). They define the illiquidity premium as the average gross return in excess of the risk-free rate for volatility-controlled portfolios that are long (short) high-illiquidity (low-illiquidity) stocks. Specifically, every three months, they: (1) sort stocks into three equal groups (terciles) based on return volatility (standard deviation of daily returns) over a lagged, rolling three-month window; (2) within each volatility tercile, sort stocks into fifths (quintiles) based on illiquidity over the same window; (3) skip one month to avoid any short-term reversal; and, (4) calculate the illiquidity premium as the average of returns of three portfolios that are long (short) the high-illiquidity (low-illiquidity) quintile within each volatility tercile. They groom the sample by excluding stocks that trade infrequently or exhibit extreme movements. They consider equal, value and monetary volume weightings for portfolios. Using daily price, trading volume and shares outstanding data for common stocks in 45 countries, along with estimates of market, size and book-to-market risk factors, during 1990 through 2011 (22 years), they find that:
- Most of the 45 equity markets exhibit an illiquidity premium. Across all countries over the entire sample period, the gross monthly illiquidity premium is 0.95%/0.44%/0.70% based on equal/value/monetary volume weightings. Adjusting for market, size and book-to-market factors, the respective gross monthly illiquidity alphas are 1.04%/0.54%/0.88%.
- The gross monthly illiquidity premium in emerging markets (1.29%) is about twice that of developed markets (0.71%). Corresponding gross monthly alphas are 1.04% for emerging and 0.71% for developed markets.
- The gross illiquidity premium relates negatively to global stock market return and positively to firm size, but is independent of firm book-to-market ratio. In other words, investors especially tend to demand liquidity in down markets, and small firms tend to be less liquid than large.
- The gross illiquidity premium is high in countries with low information quality and transparency. Co-movement of gross illiquidity premiums is stronger among developed countries open to foreign investors shocks.
In summary, evidence worldwide indicates that illiquid stocks tend to be cheaper (on a gross basis) than liquid stocks.
Cautions regarding findings include:
- Reported returns are gross, not net. Including realistic trading frictions commensurate with turnovers of defining portfolios may affect findings. In fact, by definition, the most illiquid stocks are more costly to trade (largest price impact of trading), and these stocks may also carry relatively high bid-ask spreads. Moreover, markets exhibiting the highest illiquidity premiums may have high transaction fees.
- Exclusion of extreme returns may suppress real distribution tail effects.
