{"id":18392,"date":"2022-03-14T11:58:21","date_gmt":"2022-03-14T11:58:21","guid":{"rendered":"https:\/\/www.quoniam.com\/?p=18392"},"modified":"2022-04-28T12:32:13","modified_gmt":"2022-04-28T12:32:13","slug":"liquidity-in-equity-markets","status":"publish","type":"post","link":"https:\/\/www.quoniam.com\/en\/article\/liquidity-in-equity-markets\/","title":{"rendered":"Equity investments in illiquid markets: Managing the trade-off between returns and costs"},"content":{"rendered":"\n
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Factor investing is an attractive investment strategy, but it is essential to remember that most academic research in this area has been conducted on large and mid-cap U.S. stocks. If we naively apply these strategies to less liquid markets, factor investing can appear even more attractive at first glance. Two prime examples are emerging markets and European small caps. Therefore, our research department strives to increase risk premiums after implementation costs, especially in these markets.<\/p>\n<\/div><\/div>\n\n\n\n

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We start by comparing the performance of multi-factor portfolios against MSCI benchmark indices in these two markets and in large- and mid-cap U.S. stocks. The multi-factor-signal used to construct the factor portfolios is an equal-weighted mix of value, size, momentum, profitability, investment (asset growth) and low beta.<\/p>\n<\/div><\/div>\n\n\n\n

Factor mix performance shows higher Sharpe ratios and better performance compared to the index<\/h5>\n\n\n\n
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Investment horizon is 1999-12-31 to 2021-12-31; MSCI USA Index (USD) for the universe of the United States; MSCI Europe Small Cap Index (USD) for the universe of European small caps; MSCI Emerging Markets Index (USD) for the emerging markets universe; Risk-adjusted performance is measured as the annualized Sharpe Ratio for factor portfolios and their respective indices.
Factor portfolios are constructed as a market-cap weighted investment in the top 33% highest ranked assets according to the multi-factor mix (value, size, momentum, profitability, investment, low beta). Source: Own calculation<\/figcaption><\/figure>\n\n\n\n
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While a simple multifactor model for US equities has significantly outperformed the market over the past 22 years, this outperformance is even greater for emerging markets and European small caps. However, these markets are considerably less liquid than US large and mid caps. Trading factor signals in these markets without taking market frictions into account would therefore lead to high transaction costs. The following chart illustrates the average daily trading volume over the last 22 years:<\/p>\n<\/div><\/div>\n\n\n\n

Significantly lower liquidity in emerging markets and European small caps<\/h5>\n\n\n\n
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Investment horizon is 1999-12-31 to 2021-12-31; MSCI USA Index (USD) for the universe of the United States; MSCI Europe Small Cap Index (USD) for the universe of European small caps; MSCI Emerging Markets Index (USD) for the emerging markets universe;
Liquidity is measured in daily traded volumes1<\/sup> by asset and equally weighted over the cross-section for each universe and over the 22 years respectively. Liquidity is calculated by month and then averaged over all months. Source: Own calculation<\/figcaption><\/figure>\n\n\n\n
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Portfolio optimization requires a short-term liquidity forecast<\/h5>\n\n\n\n

To manage trading costs, we need to manage liquidity demand. If we know that low volume is traded in a particular stock, we can only buy small amounts at a time. But the problem is more complex. When we optimize a portfolio, the resulting orders are traded in the future. Given the limited liquidity in smaller markets, it can take several days for a trade to be fully executed without demanding too much liquidity. Therefore, we cannot only use long-term average liquidity in the portfolio optimization process but also need a short-term liquidity forecast. If short-term liquidity movements are ignored when making investment decisions, the probability of falling into a costly “liquidity trap” increases. A liquidity trap occurs when liquidity turns out to be much lower than expected during portfolio construction.<\/p>\n<\/div><\/div>\n\n\n\n

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“Our research shows that ex-ante cost management in terms of reliable liquidity estimates can improve performance after transaction costs across market cycles and segments.”<\/p>\n\n <\/div>\n <\/div>\n

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Kay Stankov
\n<\/strong>Associate Research Forecasts<\/p>\n\n <\/div>\n <\/div>\n<\/div>\n<\/div><\/div>\n\n\n\n

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An advantage of a quantitative investment process is that the tradeoff between expected outperformance and expected transaction costs can be incorporated into investment decisions, resulting in higher returns net of costs. We can include not only expectations about returns and volatility in portfolio construction but also expectations of trading costs. Our research shows that ex-ante cost management in terms of reliable liquidity estimates can improve performance after transaction costs across market cycles and segments. Ex-ante cost management means finding the sweet spot between return and costs for the underlying investment strategy. Doing so, we estimate a transaction costs2<\/sup> reduction of 20% in our Emerging Markets strategy and of 25% in the European small caps strategy.<\/p>\n<\/div><\/div>\n\n\n\n

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1) Daily traded volumes are a measure of historically executed stock orders, not order book data as limit order data etc. The level of transaction costs depends on the required liquidity of a trade, which is measured by comparing the size of a trade to the typical volume traded in that stock in a given period. If a large amount of average liquidity is required, the impact of the trade on the market will move the price against the investor. While these adverse effects are limited for a small retail investor, managing institutional funds requires the systematic incorporation of liquidity in the investment process.<\/sup><\/p>\n\n\n\n

2) The transaction costs are comprised of fees, the half bid-ask spread, and adverse price movements induced by market impact.<\/sup><\/p>\n<\/div><\/div>\n\n\n\n

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Excessive liquidity, asset prices at all-time highs and inflation rates of more than five percent: even though the challenges for investors in 2022 are great, returns can still be achieved on the international capital markets with a skilful asset allocation.<\/span><\/span><\/p>\n\n <\/div>\n <\/div>\n <\/div>\n <\/a>\n <\/div>\n <\/div>\n <\/div>\n <\/div>\n<\/div><\/div>\n","protected":false},"excerpt":{"rendered":"

Factor investing is an attractive investment strategy, but it is essential to remember that most academic research in this area has been conducted on large and mid-cap U.S. stocks. If we naively apply these strategies to less liquid markets, factor investing can appear even more attractive at first glance. Two prime examples are emerging markets […]<\/p>\n","protected":false},"author":15,"featured_media":18355,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"_seopress_robots_primary_cat":"none","_seopress_titles_title":"Equity investments in illiquid markets","_seopress_titles_desc":"European small caps and emerging markets stocks can offer attractive returns and alpha opportunities. ","_seopress_robots_index":"","footnotes":""},"categories":[44],"tags":[41,64],"class_list":["post-18392","post","type-post","status-publish","format-standard","has-post-thumbnail","category-article","tag-equities","tag-factor-investing"],"acf":[],"_links":{"self":[{"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/posts\/18392","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/users\/15"}],"replies":[{"embeddable":true,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/comments?post=18392"}],"version-history":[{"count":26,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/posts\/18392\/revisions"}],"predecessor-version":[{"id":18958,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/posts\/18392\/revisions\/18958"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/media\/18355"}],"wp:attachment":[{"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/media?parent=18392"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/categories?post=18392"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.quoniam.com\/en\/wp-json\/wp\/v2\/tags?post=18392"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}