Multi-factor Stock Selection Strategy Incorporating Liquidity Risk

Abstract

As an emerging market dominated by retail investors, China's stock market is greatly affected by external shocks such as market noise and policy changes, and the traditional fundamental factors have limited ability to predict the future returns of stocks. Stock liquidity is also affected by noise factors and macro factors, which can be regarded as one of their external performance. Based on the multi-factor stock selection model, this paper uses the 2010-2022 CSI 300 stock data to construct a fundamental fusion factor and another fusion factor considering both fundamental and liquidity risk factors, then compares the stock selection effect of the two fusion factors through a variety of test indicators. The empirical results show that the IC value of the fusion factor considering both fundamental and liquidity risk factors is 0.0267, which is greatly improved compared with the fundamental fusion factor with IC value of only 0.0195, and its excess yield of 64.728% is 13.134% higher than the fundamental fusion factor, while the benchmark win rate is increased by nearly 3% and the maximum retracement is reduced by nearly 12%. The research shows that the effectiveness and stability of the fusion factor after adding the liquidity index to predict the future return of the stock and obtain the excess profits are better than the fundamental fusion factor. Therefore, considering the measurement and inclusion of stock liquidity level can improve the yield of stock selection strategy in the Chinese stock market to a certain extent.