Liquidity Factor

Some assets are easy to trade in large size at a fair price; others are not. Investors generally require extra return for holding illiquid assets, because selling them can be slow or costly, especially in a crisis. The liquidity factor, or illiquidity premium, describes this extra return. It appears in stocks, bonds and private markets, and it is closely related to the risk that liquidity suddenly dries up across the market. Understanding it helps investors decide when illiquidity is worth accepting.

Measuring illiquidity#

The Amihud measure, introduced by Yakov Amihud in 2002:

illiquidity = average over days of (|daily return| / daily dollar volume)

Higher values mean prices move more per dollar traded: less liquid.

The evidence#

• Amihud and Mendelson (1986) found that stocks with wider bid ask spreads earned higher returns, consistent with investors requiring compensation for trading costs.
• Amihud (2002) found that illiquid stocks earned higher returns and that market wide illiquidity affected expected returns.
• Pástor and Stambaugh (2003) found that stocks more sensitive to market liquidity shocks earned higher returns, a "liquidity risk" premium separate from illiquidity itself.

Two related ideas#

Assets that become hard to sell exactly when investors most need cash, as in 2008 or March 2020, carry the most painful liquidity risk. See Liquidity Risk.

Where the illiquidity premium appears#

Harvesting the premium#

• Patient investors with long horizons and stable funding, such as endowments, can hold illiquid assets.
• Liquidity providers earn a premium by trading when others must, such as market makers and contrarian buyers in crises. See Market Making.
• Costs matter: the premium can be eaten by the very trading costs that create it, especially for active strategies.

Risks#

• Forced selling when you need liquidity.
• Valuation uncertainty: illiquid assets may be marked at stale prices, understating risk. See Autocorrelation and Partial Autocorrelation.
• Crisis correlation: illiquid assets tend to fall together in stress.
• Capacity limits. See Alpha Capacity and Crowding.

Frequently asked questions#

What is the liquidity premium?#

The extra return investors demand for holding assets that are harder or more costly to trade.

How is stock illiquidity measured?#

With measures such as bid ask spreads, turnover and the Amihud ratio, which compares absolute returns with dollar trading volume.

What is liquidity risk?#

The risk that an asset becomes hard to sell, or loses value, when market wide liquidity dries up, often during crises.

Next, learn about growth, investment and dividend factors in Growth and Dividend Factors.