Liquidity & Factor Performance

How Do Minimum Liquidity Requirements Impact Factor Returns?

January 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Most institutional investors can only trade the largest, most liquid stocks
  • Introducing minimum liquidity requirements impacts factors differently
  • Factor portfolio construction with liquidity constraints is especially challenging in small stock markets

INTRODUCTION

Index funds have breached $11 trillion assets under management in late 2019 to the detriment of active managers according to data from Morningstar. As passive investing has increased in popularity, critical voices have become louder and various accusations have been made. Some of them have merit, most do not.

However, there is little debate on attributing the shift in trading to the closing auction when ETFs create new and cancel units for establishing the daily net asset values. Data from the French regulator AMF shows that the amount of shares traded in the closing auction has been increasing significantly in recent years and reached 44% in Madrid, 40% in London, 39% in Paris, and 36% in Frankfurt as of 2019. In contrast, less than 15% of the daily volume is traded in the closing auction at NYSE ARCA, partially because the ETF pricing mechanics are different in the US compared to Europe.

Liquidity attracts liquidity and investors focused on trading intraday will be negatively impacted by this development. However, most investment strategies do not require frequent rebalancing, where participating in the closing auction poses less of a risk. 

A larger risk for investment strategies is that as they are successful and gather further assets under management they need to restrict the universe of stocks by focusing exclusively on highly liquid securities. It is questionable if the same returns can be generated when avoiding less liquid stocks. For example, factor investing is frequently challenged as being overly reliant on stocks with small capitalization that are not suitable for institutional investors.

In this short research note, we will explore imposing minimum liquidity requirements for the Value and Momentum factors.

METHODOLOGY

We focus on the Value and Momentum factors in the US and Hong Kong stock markets. The factor performance is calculated by constructing long-short beta-neutral portf