How Liquidity of Stock Affects Its Future Expected Return

The liquidity of a stock is of concern to traders who want to execute a large order at reasonable prices without making a big impact on the market. A stock liquidity level is, however, also a factor influencing the stock expected return. Along this line, Reference [1] examined how a stock’s liquidity volatility affects its future performance.

Chordia et al. (2001) find an interesting and puzzling result that the volatility of turnover ratio is negatively related to subsequent stock returns in the U.S. market. We extend the analysis to 43 global equity markets, and test this liquidity-volatility-return relationship using not only the turnover ratio but also other liquidity measures such as the Amihud illiquidity ratio and the percentage of zero-return days. We find that the negative premium of liquidity volatility is not limited to the U.S. market or a particular liquidity measure. Instead, it is robust in the majority of global equity markets and across different liquidity measures, and holds up to the inclusion of additional controls such as the idiosyncratic return volatility.

In other words, the article pointed out that the negative volatility premium is a universal phenomenon that occurs in the majority of global equity markets and across different liquidity measures.  Practically speaking, when a stock's liquidity decreases, it will likely decline in the following months.

Consistent with the literature, we show that liquidity decrease has much stronger impact on the next-month stock returns than liquidity increase, because of the collateral-constraint effect as proposed by Brunnermeier and Pedersen (2009) and others. Hence, for a stock with high liquidity volatility, it is more likely to have a large price decline following a large magnitude of liquidity decrease, and such large price decline cannot be fully offset by the price appreciation even following the same magnitude of liquidity increase because of the asymmetric pattern mentioned above.

In summary, a stock's liquidity is important not only because of the issues associated with the order execution but also because it affects the future performance of the stock. Therefore, fund managers should take liquidity into consideration when constructing investment portfolios.

References

[1] Feng, Frank Yulin and Kang, Wenjin and Zhang, Huiping, Liquidity Shocks and the Negative Premium of Liquidity Volatility Around the World (2021). https://ssrn.com/abstract=3930591

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