Liquidity as factor

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Liquidity as factor

Postby larryswedroe » Fri Jun 28, 2013 8:51 am

http://www.cbsnews.com/8301-505123_162-57591313/profiting-from-harder-to-sell-stocks/

New paper examines the factor and if funds can access the premium

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Re: Liquidity as factor

Postby M1garand30064 » Fri Jun 28, 2013 10:18 pm

Interesting. How would you control fund expenses with a strategy like this? You'd think that would be a big barrier to this strategy.
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Re: Liquidity as factor

Postby stevewolfe » Sat Jun 29, 2013 7:09 am

I think Mike at LongTermReturns.com (sadly no more) hit it on the head when he questioned whether or not the long term out performance of small cap stocks was, in fact, more of a liquidity story - particularly pre-1980 or so. Interesting topic, thanks Larry - would love to hear your opinion on that.
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Re: Liquidity as factor

Postby garlandwhizzer » Sat Jun 29, 2013 12:58 pm

Let me get this straight. Now there are, other than the market factor, 5 factors: size, value, profitability, momentum, and liquidity. I'm wondering if it's possible to take advantage of this in a practical sense since two factors (value and liquidity) are in conflict with two others (momentum, profitability). It appears to suggest that there are multiple often mutually exclusive approaches to achieve alpha. These factors are well known to investment professionals and money managers who to exploit them and perhaps overgraze the available and limited supply of alpha. Whether or not they'll be successful going forward is at least in my mind uncertain and clearly they'll increase investment costs and tax efficiency relative to indexes in TSM or SC.

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Re: Liquidity as factor

Postby Simplegift » Sat Jun 29, 2013 1:14 pm

garlandwhizzer wrote:I'm wondering if it's possible to take advantage of this in a practical sense since two factors (value and liquidity) are in conflict with two others (momentum, profitability).

Actually, this divergence you've identified is becoming the new basis for portfolio diversification. By combining, for example, the profitability and value risk factors in the same equity portfolio, one purportedly gets higher returns with less volatility, as they have a low correlation with one another. In effect, these five risk factors now seem to be morphing into the new "asset classes" for portfolio diversification — at least in the investment literature. For example:

Combining Quality Growth with Value and Momentum
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Re: Liquidity as factor

Postby nedsaid » Sat Jun 29, 2013 9:15 pm

Gosh, I see a bit of cognitive dissonance on this forum. I am suffering from a bit of it myself. First, we are told that market returns are random and that indexing is the way to go. The slicers and dicers come along and convince me of the small cap and value premium. Larry Swedroe comes along and convinces me of the momentum and liquidity premiums. I feel a bit like the old man and the donkey in Aesop's fable.

My take on this is that the small cap and value premiums can be captured by individuals, but they have to be patient to get it. I think the momentum premium exists but that it is darned hard to capture because a lot of other folks are trying to capture it. The liquidlity premium might be capturable if an investor can get into a good Micro-Cap fund. The quality premium (the Buffett effect) is possibly capturable but if implies stock picking or good screening by computers. Or one could just go simple and index everything.

The cognitive dissonance comes about because on the one hand markets are efficient and returns are random. On the other hand, there are certain factors that seem to cause outperformance. So are markets efficient or are they not? Are returns random or are they not?

Can there be both a value premium and a momentum premium (which is growth investing on steroids)?

So I can see why people are confused.
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Re: Liquidity as factor

Postby garlandwhizzer » Sun Jun 30, 2013 1:41 pm

Simplegift wrote
Actually, this divergence you've identified is becoming the new basis for portfolio diversification. By combining, for example, the profitability and value risk factors in the same equity portfolio, one purportedly gets higher returns with less volatility, as they have a low correlation with one another. In effect, these five risk factors now seem to be morphing into the new "asset classes" for portfolio diversification — at least in the investment literature. For example:

Combining Quality Growth with Value and Momentum


I read with great interest the article you quoted which discusses combining gross profitability, momentum, and value into one holding and demonstrates it's increased returns and decreased volatility relative to unblended total index, value, profitability, quality, and momentum strategies. It makes a very convincing case based on historical performance looking at the past. It is however a very complicated strategy that he outlines which increases costs and reduces tax efficiency relative to market indexes. Difficult to implement but he does say that he advises two mutual funds, one in global equity and one in small cap equity, AZSPX, where those investors who do not wish to do the legwork can access this strategy.

I then went to Morningstar to check out the performance of AZSPX, the small cap version of this strategy which also accesses the small cap premium. Lots of premiums and lots of expected alpha, this fund has been in existence for a little over 3 years. During that time period it has actually underperformed the Morningstar Small Cap Index. So the question is: why hasn't this bulletproof strategy worked in the last 3 years? Perhaps the fund doesn't fully employ the strategy, perhaps it's just been an atypical 3 years, or perhaps it's much more difficult for a real life fund working in real time to reproduce excess returns for investors given its 1.17% expense ratio. Whatever the reason, it seems clear that it is more difficult to make money for investors with sophisticated strategies than it is publish papers supporting the validity of those strategies. I'll stay on the sidelines watching AZSPX for now.

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Re: Liquidity as factor

Postby richard » Sun Jun 30, 2013 2:08 pm

There are no doubt a large number of risk factors that affect returns. The question is what to do about it.

Some say we should diversify by factors. I have yet to see a good argument why this makes any sense.

If markets are efficient, the best mix of securities for the representative investor is the cap-weighted market portfolio, and moving away only makes sense if you are meaningfully different from the representative investor. It is impossible for everyone to be different from the representative investor in the same direction.

Put another way, if you believe in, for example, the Fama-French three factor model, then a portfolio's risk is explained by exposure to the three factors. It's not exposure to the three factors plus additional points for heavy slicing and dicing.
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Re: Liquidity as factor

Postby momar » Sun Jun 30, 2013 2:11 pm

nedsaid wrote:Gosh, I see a bit of cognitive dissonance on this forum. I am suffering from a bit of it myself. First, we are told that market returns are random and that indexing is the way to go. The slicers and dicers come along and convince me of the small cap and value premium. Larry Swedroe comes along and convinces me of the momentum and liquidity premiums. I feel a bit like the old man and the donkey in Aesop's fable.

My take on this is that the small cap and value premiums can be captured by individuals, but they have to be patient to get it. I think the momentum premium exists but that it is darned hard to capture because a lot of other folks are trying to capture it. The liquidlity premium might be capturable if an investor can get into a good Micro-Cap fund. The quality premium (the Buffett effect) is possibly capturable but if implies stock picking or good screening by computers. Or one could just go simple and index everything.

The cognitive dissonance comes about because on the one hand markets are efficient and returns are random. On the other hand, there are certain factors that seem to cause outperformance. So are markets efficient or are they not? Are returns random or are they not?

Can there be both a value premium and a momentum premium (which is growth investing on steroids)?

So I can see why people are confused.

The idea is that they are exposing you to additional types of risk.

The other idea is that the people doing this are data miners, not scientists. In 20 years we have gone from 3 factors to 6 factors. Maybe they really all do exist, but in that case all these professors ought to be embarassed about taking decades to find them. And regardless, some of the advocates ought to feel embarassed for berating skeptics as know nothings who ignore evidence when the evidence is clearly incomplete.
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Re: Liquidity as factor

Postby Simplegift » Sun Jun 30, 2013 2:14 pm

garlandwhizzer wrote:So the question is: why hasn't this bulletproof strategy worked in the last 3 years? Perhaps the fund doesn't fully employ the strategy, perhaps it's just been an atypical 3 years, or perhaps it's much more difficult for a real life fund working in real time to reproduce excess returns for investors given its 1.17% expense ratio.

Yes, one can now look at other funds that incorporate these new risk factors — including AQR Momentum (AMOMX) and AQR Core Equity (QCELX, which uses momentum, profitability and value), among other funds. But the track records of these new funds are either too short, or their performance is indistinguishable from their tracking indexes so far.

I expect proponents of these new risk factors would say that the benefits are only recognized over very long investment periods — on the order of decades and not years. This has certainly been true for the more well-known risk factors, such as small and value, which have excelled in some backtested time periods and lagged significantly in others.
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Re: Liquidity as factor

Postby richard » Sun Jun 30, 2013 2:21 pm

momar wrote:The other idea is that the people doing this are data miners, not scientists. In 20 years we have gone from 3 factors to 6 factors. Maybe they really all do exist, but in that case all these professors ought to be embarassed about taking decades to find them. And regardless, some of the advocates ought to feel embarassed for berating skeptics as know nothings who ignore evidence when the evidence is clearly incomplete.

Scientists start with a theory and test it. Data miners tend to run lots of screens and see which works best.

What's the theory for profitability (revenue minus costs of good sold compared to assets) being a better metric than any number of similar metrics? All I see is reports that it works better, not that there's any underlying theory.

The closest to a theory I've seen for profitability is that revenue minus COGS avoids many of the accounting problems with earnings. If nothing else, assets (as measured on the books) is prone to many accounting problems, so accounting purity can hardly be the justification.
Last edited by richard on Sun Jun 30, 2013 2:23 pm, edited 1 time in total.
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Re: Liquidity as factor

Postby ogd » Sun Jun 30, 2013 2:22 pm

I also think that the predictive power of these factors has to diminish when the market notices them. The stronger they are, the more the market will fight back. It's doesn't work the same as in medicine (where a lot of this methodology is being used) -- lung cancer does not react to the correlation with smoking once discovered. People smoke less, but the correlation stays the same.

If I believed that the market was so easily duped, I might as well go hopping between Consumer Staples (in good times) and Consumer Discretionary (in bad times), or is it the other way around? like the talking heads on CNBC are advising all the time.
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Re: Liquidity as factor

Postby richard » Sun Jun 30, 2013 2:26 pm

ogd wrote:I also think that the predictive power of these factors has to diminish when the market notices them. The stronger they are, the more the market will fight back. It's doesn't work the same as in medicine (where a lot of this methodology is being used) -- lung cancer does not react to the correlation with smoking once discovered. People smoke less, but the correlation stays the same.

If I believed that the market was so easily duped, I might as well go hopping between Consumer Staples (in good times) and Consumer Discretionary (in bad times), or is it the other way around? like the talking heads on CNBC are advising all the time.

It depends on whether the factors represent genuine economic risks. It's not unreasonable to hope for higher returns as a compensation for taking more risk. Things that are not genuine economic risks are more likely to disappear.
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Re: Liquidity as factor

Postby ogd » Sun Jun 30, 2013 2:40 pm

richard wrote:It depends on whether the factors represent genuine economic risks. It's not unreasonable to hope for higher returns as a compensation for taking more risk. Things that are not genuine economic risks are more likely to disappear.

Yes but for these factors to be attractive you must believe that you are getting more than the adequate reward for the risk taken (otherwise you might as well put more money in TSM). In other words, a free lunch. Which might persist for a while, but I think eventually it will go away.
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Re: Liquidity as factor

Postby nedsaid » Sun Jun 30, 2013 3:10 pm

An interesting thread to say the least.

I think the best thing that investors can do is to have consistency in their approach. It doesn't help to adopt a new strategy just at the time it stops working. I confess to tinkering to try to capture excess returns.

I started as a value and dividends guy with individual stocks. Still have them. Graduated onto Value fands as well.

My favorite mutual fund family primarily manages its funds for earnings and price momentum. They have value funds as well and quantitative funds that use index optimization techniques. I own funds with that family with all three styles.

I learned about indexing and over time have indexed about 25% of my portfolio. I wanted market returns and to reduce my fees.

I learned about the value and small cap premiums from the folks at Merriman and learned "slice and dice" from them. This refined the approach I was already taking.

So I fess up. My portfolio has attempted to capture most of these premiums. Pretty much I have diversified not only across asset classes but also investment styles. Though when you run this portfolio through Morningstar, it tilts towards value and a tilts a bit more than that to small and mid cap stocks.

I would like to think that I have captured the "Quality" premium, but my stock picking skills were less than Warren Buffett or Peter Lynch's. I doubt my individual stocks have matched the market return but have been close.

I bought a Micro-Cap EFT to capture the excess returns of the Micro-Cap sector but Morningstar said that traders front running this fund and fund expenses have probably nullified any liquidity premium from this fund. Oh well.

So I have not been a very good Boglehead in the process, but learned a heck of a whole lot. It is also gratifying to me that I was attempting to capture these premiums "before they were cool" and before I heard of Larry Swedroe. Whatever my flaws as an investor, at least I was trying to think ahead and showed an openness to new ideas. These different investment approaches wax and wane and wax again over time. I pretty much have kept what I had so I have not suffered from errors in market timing. It takes a lot for me to give up on an investment, every style has its day and I did not want to sell just before the strategy started working.

In other threads, I have expressed skepticism towards purely quant approaches towards investing because I have owned funds that practiced these techniques with mixed success. Sometimes these strategies work brilliantly and other times not so well. I have expressed skepticism over people trying the "fat tails" portfolios because I have observed the behavior of different asset classes over the years. I noticed that pieces of my portfolios often didn't behave the way I expected.

So it has been fun. My investments have performed about as expected, hard to say if I have captured the excess return I wanted. At least the diversification plan worked and I got some good returns through tough years. Not due to my brilliance but being diversified. Also due to not panicking in bad markets.
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Re: Liquidity as factor

Postby momar » Sun Jun 30, 2013 5:23 pm

nedsaid wrote:So I fess up. My portfolio has attempted to capture most of these premiums. Pretty much I have diversified not only across asset classes but also investment styles. Though when you run this portfolio through Morningstar, it tilts towards value and a tilts a bit more than that to small and mid cap stocks.

I agree with your main point that a consistent approach is key. But the ultimate in "diversifying across investment styles" is owning the total market, wherein you have the average of all investing styles. Deviating from this is concentrating your "investment style diversification", regardless of its wisdom.
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Re: Liquidity as factor

Postby Ketawa » Sun Jun 30, 2013 8:07 pm

richard wrote:If markets are efficient, the best mix of securities for the representative investor is the cap-weighted market portfolio, and moving away only makes sense if you are meaningfully different from the representative investor. It is impossible for everyone to be different from the representative investor in the same direction.


I think there are plenty of reasons for investors to deviate from the market portfolio. There is no reason that the total market cap-weighted portfolio should be the best portfolio for me and someone as different as an institutional investor. We have different liquidity needs. We have different investing horizons. As an individual investor, I am not subject to the whims of a state government, or satisfying voters. I don't have to worry about the market impact of my investing decisions.

As a member of the military, I have far greater ability to take risk with small cap and value stocks. If I can capture the liquidity factor in a fund, it might be a good idea for me to do it, since I don't need much liquidity. I can have a higher allocation to stocks since my job is not influenced by the business cycle.

I'm not surprised that liquidity has been shown to be a factor in determining returns. It seems like common sense to me, even more so than the value premium.
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Re: Liquidity as factor

Postby dumbmoney » Sun Jun 30, 2013 10:05 pm

There's something a little strange about trying to get a liquidity premium from an open-ended fund, which itself is perfectly liquid (buy/sell at NAV, no spread).
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Re: Liquidity as factor

Postby richard » Mon Jul 01, 2013 6:21 am

ogd wrote:
richard wrote:It depends on whether the factors represent genuine economic risks. It's not unreasonable to hope for higher returns as a compensation for taking more risk. Things that are not genuine economic risks are more likely to disappear.

Yes but for these factors to be attractive you must believe that you are getting more than the adequate reward for the risk taken (otherwise you might as well put more money in TSM). In other words, a free lunch. Which might persist for a while, but I think eventually it will go away.

Either that or your risks have to be different from the general market's risks. If you are much less sensitive to liquidity, for example, you may be able to profit on a risk-adjusted basis by taking on more liquidity risk.
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Re: Liquidity as factor

Postby richard » Mon Jul 01, 2013 6:26 am

Ketawa wrote:
richard wrote:If markets are efficient, the best mix of securities for the representative investor is the cap-weighted market portfolio, and moving away only makes sense if you are meaningfully different from the representative investor. It is impossible for everyone to be different from the representative investor in the same direction.

I think there are plenty of reasons for investors to deviate from the market portfolio. There is no reason that the total market cap-weighted portfolio should be the best portfolio for me and someone as different as an institutional investor. We have different liquidity needs. We have different investing horizons. As an individual investor, I am not subject to the whims of a state government, or satisfying voters. I don't have to worry about the market impact of my investing decisions.

As a member of the military, I have far greater ability to take risk with small cap and value stocks. If I can capture the liquidity factor in a fund, it might be a good idea for me to do it, since I don't need much liquidity. I can have a higher allocation to stocks since my job is not influenced by the business cycle.

I'm not surprised that liquidity has been shown to be a factor in determining returns. It seems like common sense to me, even more so than the value premium.

Right. If you're meaningfully different from the representative (or "average") investor, then you may well be better off deviating from the market portfolio.

Liquidity has long been recognized as a risk. It does seem like common sense, with a perfectly straightforward economic theory. The value story involves value being a proxy for some underlying economic issue, such as distress, or being a behavioral story or just being an anomaly.
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Re: Liquidity as factor

Postby YDNAL » Mon Jul 01, 2013 7:42 am

momar wrote:The other idea is that the people doing this are data miners, not scientists. In 20 years we have gone from 3 factors to 6 factors. Maybe they really all do exist, but in that case all these professors ought to be embarassed about taking decades to find them. And regardless, some of the advocates ought to feel embarassed for berating skeptics as know nothings who ignore evidence when the evidence is clearly incomplete.

True !

Stay tuned.... in 2015, we look into "neutrality" premium (no HmL, SmB) - wait, Mel Lindauer's unloved [blended] Mid Caps. :D
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