The biggest common factor that connects the stocks in my portfolio is that they are all (relative) illiquid. If you have two almost identical assets, one liquid and one illiquid, the most attractive asset is obviously the liquid one because illiquidity is a real risk:
- You can never be totally certain that you don’t need money on short notice.
- An illiquid stock also makes it hard to profit from superior insight. For example: you can’t turn on a dime and exit when you change your mind.
The question of course if how much you want to be paid for illiquidity risk, and how much the market is willing to pay you for that risk. In my opinion you shouldn’t be paid a whole lot to take on illiquidity risk. The main reason is that stocks are only a suitable investment if you have a long-term horizon. But why would you need intraday liquidity if you are holding an asset for a multi-year period? The answer is simple: you don’t! The value of being able to trade out of your position in a few microseconds is negligible when your intention is to hold it for years or even decades.
So if the market is willing to pay you a significant premium for holding an illiquid asset it’s a deal you should take, and there is a lot of academic research that suggests that the illiquidity premium is sizable. The paper “Liquidity as an Investment Style” contains to following table that shows that low liquidity stocks outperform irrespective of size:
As is visible the difference in performance is huge. Especially when we look at the microcap segment where it is a whopping 14% per annum while taking less risk at the same time (if we accept the standard deviation as a risk measure). I don’t know if I’m able to add alpha to my portfolio. I of course think that I do, but by structuring my portfolio in a such a way that I have exposure to factors that have outperformed in the past I’m hedging my bets. Besides a bet on illiquidity my portfolio is of course also a bet on small-sized firms and value stocks.
And the big question is of course: can we expect that the illiquidity premium persists in the future? I think that it will because of how the financial services industry is structured. Most individual investors don’t really need very liquid assets because they do have a long-term horizon. But they do park their money in ETF’s, mutual funds and hedge funds, and the managers of those funds can’t afford to buy illiquid assets. They never know when their investors want to withdraw, so they always have to plan for the worst.
As an individual investor you don’t face this risk, and because of that illiquid assets are a great match if you want to generate high returns over a long-term horizon. I think that is (or should be) the goal of most investors, but as long as they don’t realize what they are implicitly paying for the liquidity they don’t use they will be at a disadvantage.
Author is long a lot of (relative) illiquid stuff