In a new interview with Morningstar, Roger Ibbotson explains why liquidity (or the lack thereof, to be precise) should be considered a distinct risk factor in equity investing.

This is an intriguing idea that I analyzed in some detail in the June 2010 issue of The Beta Investment Report. From an investment perspective, the case for carving out liquidity as a separate beta looks compelling, based on Ibbotson’s research. Why? Part of the answer is that the liquidity premium has a history of independence from the usual beta suspects, namely: the broad equity market factor, the small-cap factor and the value factor. In other words, stocks with relatively low liquidity are linked to a risk premium that’s not driven by the Fama-French three-factor model.
The liquidity premium also seems to explain the mystery of why value stocks have historically earned a higher return than the broad market with lower volatility. As the June issue of the newsletter observed:

Decades of financial research advise that higher return arrives only by embracing higher risk. On its face, value stocks look like a breach of conventional finance theory. The implication: the equity market isn’t efficient and perhaps irrational as well. But parsing equity returns through the prism of liquidity suggests otherwise. To be precise, small-cap value harbors more risk—more liquidity risk.

Low-liquidity stocks exhibit lower volatility, but not because they’re less risky. Instead, the low vol is directly related to the fact that they trade less often. In essence, this phenomenon can be summed up by the old Wall Street adage: “It takes volume to make prices move.” In fact, studies over the years show this to be true, i.e., higher volume tends to be associated with a higher absolute change in price over time.
In an effort to isolate and capture the liquidity premium, Ibbotson and his firm Zebra Capital Management recently launched a pair of mutual funds in partnership with American Beacon Advisors. It’s too soon to say if Ibbotson’s research on liquidity has made a successful transition from research to the real world, although this strategy is worth monitoring.
Meantime, take a few minutes and listen to Ibbotson’s commentary…