Few pieces I've ever written generated as much interest as Financial Advisor's Big Picture column in the September issue on Roger Ibbotson's research into the amazing premium the stock market accords illiquid equities.
The column was based on a presentation Ibbotson made at the first annual Innovative Alternative Investment Strategies in Chicago on July 28. They are also published in a working paper, "Liquidity As An Investment Style," that he co-authored with Zwihu Chen in July 2007 and updated in December 2007.
Readers questioned several issues raised by the research, which defined liquidity as total annual trading volume divided by shares outstanding. One question was: Were the shares of these companies so thinly traded that they might be difficult to sell? Apparently not.
Another question was: Did some of the companies have one or several large shareholders who had no intention of selling so that the float was smaller than a similar concern of roughly the same size with a more widely dispersed ownership? Apparently yes.
I e-mailed Dr. Ibbotson and asked him what were the characteristics of the illiquid equities that seemed to outperform more liquid shares so dramatically. Here is his response:
"The companies tend to have a value tilt. This is quite natural since under-appreciated companies with less trading volume tend to have less demand. We especially precluded micro-caps, because we were trying to include only liquid securities, even though we hold the relatively less liquid names.
"We do include companies with less float, including closely held companies. Separate evidence suggests that these companies perform well since incentives are better aligned between management and shareholders."