In my post on Horizon Kinetics’ Bregman, I described several factors that deter index funds. Today I look at a factor that deters not only index funds, but many institutional and speculators in general.
An interesting academic paper on this factor is the famous Ibbotson paper Liquidity as an investment style.
- Liquidity is a stronger factor for returns than size (see below by comparing columns).
- Another interesting finding is that the value effect is stronger in illiquid companies, so strong that it overshadows the size effect (see below and compare most liquid smallest companies with most liquid largest companies). In other words, the market is less efficient in the universe of illiquid stocks
- Fama would not agree with me as he argues value stocks are more risky in general and that risk is more nuanced than simple volatility (for example, we do not know when the prospensity for risk is lowest), but this is debunked in the famous Lakonishok et al. ’94 paper Contrarian investment, Extrapolation and Risk and an updated 2009 study. The papers show that not only is value less volatile than glamour in general, it outperforms glamour in the bad states of the world, i.e. recessions, where risk aversion is most probably higher due to job losses and the powerful animal spirit fear.
- Many institutions are simply too large and cannot support research into these illiquid companies from a cost-benefit perspective, as they would drive up the price to build an economically meaningful position
- Total friction costs for an investor are driven by liquidity and total trading volume. Ideally, an investor in illiquid stocks should
- be small,
- have a low turnover portfolio
The other benefits of low turnover tie into one of my favorite passages in the book I am currently reading, Capital Returns by Edward Chancellor. Low turnover* allows the investor to minimize the amount of decision making. Having to make a lot of decisions disproportionately increases errors by increasing time pressure. The pressure of highly frequent decision making is a disincentive to long term thinking about hard questions that matter. Guy Spier talks about the benefits of reducing the amount of decision making too in his book The education of a value investor.
As such, illiquidity forces the investor to think twice before investing in a stock.
The right spirit to invest in illiquid stocks is to worry about being right.
In my investing experience, illiquidity has been on balance a positive for me. Having said that, most of my investing has been in the time frame of the 2009 – 2017 bull market.
*Note that I use low turnover and not long term investing. In my view, low turnover is not a necessary condition to get the label “long term investor” and is not to be worshipped as an end in itself. Long term is merely a succession of short terms, and rational fundamental-driven investors should be willing to act short term if Mr. Market provides the opportunity to close a position at a margin of safety that is inadequate.