Liquidity Style in European Stock Market
Aho, Sami (2021)
Aho, Sami
2021
Tuotantotalouden DI-ohjelma - Master's Programme in Industrial Engineering and Management
Johtamisen ja talouden tiedekunta - Faculty of Management and Business
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Hyväksymispäivämäärä
2021-09-14
Julkaisun pysyvä osoite on
https://urn.fi/URN:NBN:fi:tuni-202105104769
https://urn.fi/URN:NBN:fi:tuni-202105104769
Tiivistelmä
Liquidity, the ability to trade assets quickly without significant trading cost or price impact, has a compelling economic intuition for explaining an excess premium: investor want liquidity for the ability to exit positions quickly and are willing to pay for it and thus, long-term investors of illiquid stocks should be rewarded with a premium. But still, even though the cross-sectional relation between stock’s liquidity and future returns, the liquidity style, has been researched extensively in the past 30 years, no consensus has been reached on whether a liquidity premium exists.
Most studies have been conducted in the U.S. stock market using only a single measure of liquidity as the style characteristic. This study replicates the analysis framework of a study conducted by Ibbotson, et al. (2013) to find out if a liquidity premium exists in the European stock market using a composite liquidity measure consisting of four different academic liquidity measures. Additionally, it answers the open questions on how estimated transaction costs affect the liquidity premium and whether liquidity premiums can be attributed to certain market regimes.
The scope of the study is the primary European exchanges from January 2000 to December 2020. The liquidity style is compared against size, value, and momentum styles through various analysis, where each style is split in quartile portfolios based on their respective ranking variables. Estimated transaction costs are analysed using a simple model based on portfolio turnover and bid-ask spread. Monthly liquidity style returns are examined against market returns, volatility and maximum drawdown to find out if liquidity premium stems from a specific market regime.
The study finds that the most illiquid quartile portfolio return is similar to other style top quartile portfolio returns and overperforms the market return. Portfolio turnover ratios among the style portfolios are similar, except for momentum having the highest turnover. In terms of portfolio composition, liquidity style is clearly different from value and momentum styles but shares similarities with the size style. Liquidity effect (higher returns for more illiquid stocks) was present across different size quartiles, but this was not true the other way around, indicating that size could be a proxy for liquidity. The long-short liquidity factor premium was positive but insignificant after controlling risk for market, size, value, and momentum factors. The removal of size risk control from the regression model made the liquidity premium positive and significant. The liquidity premium is observed to dissipate after applying estimated transaction costs, which implies that the liquidity effect could be hard to exploit in a practical setting. The liquidity style is found to resemble low
beta strategies, hence overperforming the market in downturns.
Most studies have been conducted in the U.S. stock market using only a single measure of liquidity as the style characteristic. This study replicates the analysis framework of a study conducted by Ibbotson, et al. (2013) to find out if a liquidity premium exists in the European stock market using a composite liquidity measure consisting of four different academic liquidity measures. Additionally, it answers the open questions on how estimated transaction costs affect the liquidity premium and whether liquidity premiums can be attributed to certain market regimes.
The scope of the study is the primary European exchanges from January 2000 to December 2020. The liquidity style is compared against size, value, and momentum styles through various analysis, where each style is split in quartile portfolios based on their respective ranking variables. Estimated transaction costs are analysed using a simple model based on portfolio turnover and bid-ask spread. Monthly liquidity style returns are examined against market returns, volatility and maximum drawdown to find out if liquidity premium stems from a specific market regime.
The study finds that the most illiquid quartile portfolio return is similar to other style top quartile portfolio returns and overperforms the market return. Portfolio turnover ratios among the style portfolios are similar, except for momentum having the highest turnover. In terms of portfolio composition, liquidity style is clearly different from value and momentum styles but shares similarities with the size style. Liquidity effect (higher returns for more illiquid stocks) was present across different size quartiles, but this was not true the other way around, indicating that size could be a proxy for liquidity. The long-short liquidity factor premium was positive but insignificant after controlling risk for market, size, value, and momentum factors. The removal of size risk control from the regression model made the liquidity premium positive and significant. The liquidity premium is observed to dissipate after applying estimated transaction costs, which implies that the liquidity effect could be hard to exploit in a practical setting. The liquidity style is found to resemble low
beta strategies, hence overperforming the market in downturns.