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Stock-Level Liquidity – Alpha or Risk?

Most investors do not associate stock-level liquidity as a stock selection signal, but as a measure of how easily a trade can be executed without incurring a large transaction cost or adverse price impact. Inspired by recent literature, such as Bali, Peng, Shen and Tang (2012), we show globally that a strategy of buying stocks with the highest one-year change in stock-level turnover has historically outperformed the market and has outperformed strategies of buying stocks with strong price momentum, attractive valuation, or high quality. One-year change in stock-level turnover has a low correlation (i.e., <0.15) with commonly used stock selection signals. When it is combined with these signals, the composites have yielded higher excess returns and information ratios (IR) than the standalone raw signals.

Key Findings:

  • In the U.S., a strategy of buying stocks with the highest one-year change in turnover outperformed the market and outperformed strategies of buying stocks with attractive valuation, strong price momentum, or high quality by 4.73%, 0.66%, 1.44% and 2.03% per year, respectively.
  • One-year change in stock-level liquidity has low correlations (<0.15) with commonly used investment strategies. When it is added to the mix, the composites have produced higher excess returns and IRs.
  • One-year change in turnover has produced excess returns after controlling for market, size, value, and price momentum and is not driven by variations in liquidity beta.
  • Our results indicate change in turnover works due to investors’ underreaction.