Liquidity as an Investment Style

Abstract

This paper develops an Earnings-Based Liquidity Strategy that invests in both value and illiquidity 2 . We first show that liquidity, as measured by stock turnover or trading volume, is an economically significant investment style that is distinct from traditional investment styles such as size, value/growth, and momentum. We then introduce and examine the performance of several portfolio strategies, including a Volume Weighted Strategy, an Earnings Weighted Strategy, an EarningsBased Liquidity Strategy, and a Market Cap-Based Liquidity Strategy. Our backtest research shows that the Earnings-Based Liquidity Strategy offers the highest return and the best risk-return tradeoff, while the Volume Weighted Strategy does the worst. The superior performance of the Earnings-Based Liquidity Strategy is due to equilibrium, macro, and micro reasons. In equilibrium, liquid stocks sell at a liquidity premium and illiquid stocks sell at an illiquidity discount. Investing in illiquid stocks thus pays. Second, at the macro level, since higher supply of overall financial capital makes all stocks more liquid, the strategy benefits from the growing level of financialization of assets in the world, which increases the global supply of financial capital, making today’s less liquid securities increasingly more liquid over time. Other things equal, this trend implies higher future valuations for today’s illiquid stocks. Finally, at the micro level, the strategy avoids, or invests less, in popular, heavily traded glamour stocks and favors out-of-favor stocks, both of which tend to revert to more normal, earnings-adjusted trading volume over time.