Exploiting Public Stocks’ Liquidity Premium

In 2008 investors suffered a tripple whammy. They were stung by losses as markets cratered, they found their exit from hedge funds barred by “gates,” and they got an unwelcome surprise when they tried in vain to discover what investments their funds held.

Investors are vowing not to be caught with blinders on again. They want investments that are easy to understand and also offer transparency and liquidity. Indeed, if there were a spectrum of investors’ wishes, it would have opaqueness, complexity and illiquidity — characteristics of many popular investments precrash — on the far end and transparency, simplicity and liquidity on the near end.

Roger Ibbotson, the famed Yale University finance professor who sold his advisory firm, Ibbotson Associates, to Morningstar in 2006, may have found a way to take advantage of this shift in sentiment. Through the quant-driven, market-neutral hedge fund firm he founded in 2001, Zebra Capital Management, Ibbotson is packaging investments built around research that he and a colleague conducted into liquidity premiums in — of all places — the public equity markets.

It’s been known for decades, of course, that private companies offered a so-called liquidity premium: If you’re willing to lock up your money — that is, forgo liquidity — for as long as a decade, you should be rewarded. Ibbotson, however, argues that an outperformance premium for sacrificing a certain amount of liquidity can be found in major public markets in which stocks trade actively.

In June 2008 he and Zhiwu Chen, a fellow finance professor at the Yale School of Management as well as a founding partner of Zebra Capital, published research purporting to show that liquidity (as measured by stock turnover) varied widely among stocks in public markets and that it was as critical in differentiating among shares as market capitalization, earnings growth and intrinsic value.

Investors recognize that small-cap stocks tend to beat large caps over the long term. But Ibbotson goes further, insisting that his and Chen’s research establishes that less-liquid large-cap stocks in public markets deliver better returns than more-liquid large-cap stocks when all factors are considered. What’s more, he says, this liquidity factor can be exploited without the downside of strategies, like private equity, that tie up money for years and provide minimal transparency.

“Low liquidity beats high liquidity,” Ibbotson asserts. “Everybody recognizes immediately that liquidity is a very important determinant of investing success. If you buy something less liquid, you can buy that at a discount.”

During the financial crisis, however, investors got burned when they couldn’t retrieve cash from hedge funds and were contractually locked into real estate and private equity. Yale lost about 30 percent of its endowment (for the fiscal year ended June 30, 2009), largely because of illiquidity in its private investments, Ibbotson observes.

His and Chen’s Milford, Connecticut–based firm has launched U.S. long-only institutional small-cap and large-cap managed accounts that look for companies with strong fundamentals and relatively low liquidity, based on such factors as trading volume, turnover and bid-ask spreads. Zebra is now launching a Japan long-only managed account and a global long-short hedge fund, and it plans to offer five styles within subadvised mutual funds by this summer.

Ibbotson professes to be surprised that a clear-cut liquidity anomaly exists. After all, hedge funds hire mathematicians to plumb data to uncover arbitrage opportunities, which in theory should eradicate any liquidity premiums in public equity markets. In the bond market, by contrast, the liquidity premium is obvious. “If you look at two different bonds with different liquidity, those with less have higher yields,” points out Ibbotson. “What we’re focusing on is, you don’t have to go all the way to something like private equity to realize the liquidity premium [in stocks]; you can do it in publicly traded securities.”

Rumi Masih, managing director of the strategic investment advisory group at J.P. Morgan Asset Management, gives this appraisal: “It’s not just size, value or growth that can add or detract from returns. It’s also stocks’ liquidity structure. Ibbotson’s approach is a way to exploit return using that as a style of investing, and this hasn’t been used before.”

Richard Bernstein of New York–based Bernstein Capital Management says that in the mid-1990s, when he was chief investment strategist for Merrill Lynch & Co., he found results similar to Ibbotson’s for publicly traded stocks that received no or scant analyst coverage: The lack of readily available information made for less liquidity; consequently, such neglected stocks mimicked the returns of private equity. By contrast, Bernstein adds, for truly illiquid investments, the premium has all but disappeared because so much capital has discovered these assets. “In areas such as private equity, there were once huge premiums for the lack of information, for the risk involved,” he explains. “But I think those premiums have been whittled away.”

The manager of Charles Schwab & Co.’s institutional investment products group, John Sturiale, offers this perspective on the encouraging climate for Ibbotson’s straightforward liquidity-linked offerings: “After 2008 it’s about no surprises, knowing what you’re buying, knowing what you get. Clients’ tolerance for not getting that is about an inch. People were burned badly enough that for the foreseeable future, they don’t care about your exotic strategy. Vanilla is now okay.”

Joel Greenblatt, managing partner of New York–based hedge fund firm Gotham Capital, echoes the transparency-and-simplicity refrain. In fact, he has written a book about it — The Little Book that Beats the Market — in which he asserts that clients should be able to view portfolio holdings online and in real time. To capitalize on investors’ wary mood, Greenblatt recently launched an online money management firm, Formula Investing (www.formulainvesting.com), that uses proprietary stock-screening systems and a disciplined approach to managing value stocks.

The question is: Are investors willing to experiment with investments? Many pension funds, still probing their portfolios to see why some investments fared much worse than others, remain gun-shy. Despite the spectacular run-up in stocks, bonds have been drawing record amounts of cash. The CEO of Formula Investing, Blake Darcy, says that despite his firm’s overt transparency and easy-to-grasp strategy, his biggest hurdle will be getting reluctant investors to go back into stocks at all. Ibbotson faces the same challenge.