Seeking to mine gold from market inefficiencies, academics have spent decades trying to discern persistent patterns behind the statistical returns on different classes of equities. Advisors have watched them debate the merits of small-cap stocks vs. large-cap counterparts and value vs. growth.

But Roger Ibbotson, founder of the eponymous investment research and consulting firm and chairman and chief investment officer of Zebra Capital Management, has discovered another dimension to the performance analysis landscape: liquidity. Keynoting the first annual Innovative Alternative Investment Strategies conference in Chicago on July 28, Ibbotson discovered stunning return differentials with equities when they are classified according to their liquidity.

The results are published in a working paper, "Liquidity As An Investment Style," that Ibbotson co-authored with Zhiwu Chen in July 2007. It was updated in December 2009.

"Liquidity dominates size" as a return predictor, Ibbotson told attendees. "Public equity markets have gradations of liquidity with different liquidity premiums."

It should be noted Zebra Capital is launching several investment products based on the research. When one looks at the charts that accompany this article, it's easy to see why.

Ibbotson studied 3,500 U.S. stocks by quartile and rebalanced annually from 1972 to 2009. He defined liquidity as total annual trading volume divided by total shares outstanding. One takeaway from his presentation at the conference, which focused on alternative investments, was that investors don't have to go all the way down the liquidity spectrum to private equity to find additional return.
That's because Mr. Market apparently is willing to pay a higher price for the most liquid securities, reducing returns from these equities.
The notion of liquidity as an investment style makes intuitive sense. Everything else being equal, why wouldn't investors pay a higher price for the same set of cash flows if trading were cheaper and easier?

Ibbotson also turned that concept upside down. Keeping all other factors equal, why shouldn't investors pay a lower price for the same cash flows if trading costs more and requires them to expend more energy?

How much, Ibbotson asked the audience, should advisors pay for liquidity their clients don't need? Many big university endowments ran into serious problems with illiquid investments during the financial crisis, but Ibbotson confined his research in this study to public securities. And his working paper notes that the research would lead an advisor to select a portfolio biased toward more thinly traded equities that would still be relatively liquid.

Ibbotson's data produced some interesting findings. Take the small-cap universe, which is broadly presumed to generate higher returns that can be traced to a so-called size premium.

That's true for some small-cap shares, but when Ibbotson sorts smaller-company equities into different classes based on their size and liquidity over a 37-year period, some interesting facts emerge. The worst-performing group is highly liquid, small-cap stocks, which returned 5.9% annually over the period. Ibbotson's explanation is that these are micro-cap stocks that have been "pumped up."