When it comes to factor investing, advisors often hear heated arguments over the benefits of momentum, which looks at investing trends, and value, which focuses on companies’ fundamental value. But two members of Vanguard’s product team say that exposures to liquidity could also create a factor-investing premium.
“Advisors have read a lot about value and momentum in the press,” said Matt Jiannino, Vanguard’s head of Quantitative Equity Product Management, in a recent industry perspective. “But while the liquidity factor is just as enduring, it's kind of a hidden gem that people aren't aware of.”
While liquidity isn’t among the four classic Fama-French factors that most factor-based ETFs follow, Vanguard’s Quantitative Equity Group (QEG) has found that in many cases, it actually represents a premium that is targeted by small-cap strategies.
“[R]elatively less liquid securities tend to outperform their more liquid peers,” Jiannino explained. He added that the premium exists across the entire market-cap spectrum, even among large-cap stocks; order stocks with large market capitalizations according to liquidity shows, he said, and one would find that the less liquid part has outperformed.
According to Senior Product Manager Frank Chism, many investors have been getting some exposure to the liquidity premium from funds that give equal-weight exposure to names in indexes like the Russell 2000.
“I guarantee you that some of the ones at the bottom will be remarkably less liquid than the biggest ones,” Chism said. “[B]ut we would say, ‘Why would you own the superliquid ones? Why not just go after the less liquid ones?’”
Jiannino added that some big names could also be less liquid than their large-cap peers, in which case they should be targeted explicitly. Furthermore, he said, investment funds that seek the liquidity factor would allow retail investors to target the premium that larger investors like endowments and foundations pursue from investments like real estate, private equity, and fixed assets.
“With the liquidity product, you can build a nice, diversified portfolio across liquid assets, and hold less liquid names to collect the premium,” he said. “Holding a single name gets you exposure, but it comes along with all the idiosyncratic risk of holding a single asset.”
To create a fund portfolio that mirrors the liquidity factor’s performance, Chism said Vanguard examines each stock based on the average daily turnover it has experienced over the last year in terms of percentage of shares outstanding being traded. They also look at the average dollar amount being traded on a daily basis, as well as its Amihud illiquidity score, which essentially weighs the price movement in a stock against the dollar turnover measure.
“We construct the portfolio by taking the best stocks on those three measures from each of the three market-cap buckets,” he said.
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