Is the value premium a liquidity premium?

The "High minus low" strategy: Source

If you haven't read Clifford Asness and John Liew's recent article on market efficiency, you should. There's plenty of meat in the article, but the one sinew I want to chew on is this above chart. It shows the cumulative returns to a strategy called HML, or "high-minus-low."

This strategy involves going long cheap U.S. stocks (as measured by their price-to-book ratio) and simultaneously going short expensive stocks. Over the last eighty-five years or so, cheap stocks have roundly beat out expensive ones. This is called the value premium. A large part of Asness and Liew's investing effort revolves around exploiting this premium for their clients at AQR Capital Management.

Now as the authors point out, this outperformance could be due to a combination of two things. The behavioural explanation is that people are irrational, subject to various psychological tics that drive aberrations in prices. Perhaps investors are fickle and would rather plunge into sexy and expensive concept stocks than purchase boring but cheap stocks. Asness and Liew propose the idea that investment committees don't have sufficiently long windows for evaluating the performance of their investments. Whatever the explanation, by trading against the various behavioural tics, investors can earn superior profits.

The other explanation is that the value premium has a very rational underpinning. Those who buy cheap stocks and sell expensive ones need to earn a higher return because they must be compensated for bearing some sort of inconvenience, or because they are providing the market with some extra service.

What is that something? My guess is that if you were to adjust the HML strategy's results to account for the superior liquidity return provided by stocks that seem expensive, you'd probably see the returns on cheap and expensive stocks converge. What appears to be an anomaly on the chart is just the shadow of a liquidity premium. Asness and Liew aren't exploiting an irregularity, they're producing liquidity—and getting paid a fair rate for doing so.

Take two companies that are identical except that the shares of the first are more liquid than the second (yep, I've been down this road before). Given a choice of buying either of the two, investors will always prefer the more liquid share. Owning a stock with low bid-ask spreads and plenty of depth provides investors with the comfort of knowing that should some unpredictable event arise, they can easily sell their shares in order to mobilize the necessary resources to cope with the event.

We can think of people "consuming" the comfort provided by liquid shares, much like they consume the peace of mind provided by a fire extinguisher stored away in a closet. If we want more peace of mind, we need to buy a better quality fire extinguisher and/or shares with a higher degree of liquidity. If we can do with less, then we can buy a smaller fire extinguisher and/or switch into illiquid shares.

We can decompose the price of a share into two parts—the price people pay for the share's earnings, and the premium they are willing to cough up to consume the peace of mind that its liquidity provides. Since the earnings on our two shares are the same, the portion of each share's overall price that is explained by earnings will be equal. However, people will put a small premium on the consumption value of the services provided by the illiquid shares and a large premium on the superior consumption yield provided by liquid shares. The difference in premiums means that the market price of the liquid share will be higher than the illiquid one.

Because of this price discrepancy, people will typically say that the liquid share is "expensive" and the illiquid one "cheap", but these are misnomers. The liquid shares provide a stream of valuable services that the illiquid shares fail to provide, and therefore logic dictates that they must trade at a higher price. They might seem expensive relative to underlying earnings, but only if we intentionally ignore the very real flows of consumption that they provide.

By selling "expensive" stocks and buying "cheap" ones, Asness and Liew are really just selling liquidity while taking on illiquidity. In short, in exploiting the HML line they are acting as liquidity providers. Just like Kidde (a major manufacturer of fire extinguishers) provides the world with a worthy service—peace of mind—Asness and Liew are producing and selling that very same good. They are willingly holding the illiquid long positions that others would prefer not to hold, thus forgoing the peace of mind enjoyed by others. And in borrowing and selling liquid shares, they are feeding liquidity into the market that would otherwise be stranded in someone's account at a depository.

Just like Kidde should be well-compensated for its product, Asness and Liew should be appropriately rewarded for their sacrifices. As compensation, their illiquid long position will typically appreciate at a faster rate than an equivalent liquid long position. And their liquid short position will appreciate at a slower than an equivalent illiquid short position.

This difference in expected price appreciation emerges because in equilibrium, an illiquid share needs to provide the same total expected return as a liquid share. Liquid shares already provide an outsized non-pecuniary return (their ability to act as fire extinguishers). In order to counterbalance this, the illiquid share must provide an outsized pecuniary return, or a faster rate of price appreciation. I'm ignoring dividends here. (Again, see this post).

So the HML line charted above illustrates the financial compensation that flows to folks like Asness and Liew who go out of their way to fabricate financial fire extinguishers. (I don't doubt there are also behavioural reasons for it.) Or, conversely, it represents the financial return that people are willing to forgo in order to consume the services provided by liquid shares.

To some degree, Asness and Liew's HML strategy reminds me of the strategy used by Long Term Capital Management. LTCM did a lot of convergence trades in treasury markets. It shorted "on-the-run" bonds, the most recent vintage of debt issued by the government, while purchasing "off-the-run" bonds. On-the-run bonds attract more liquidity than an equivalent off-the-run bonds, and therefore trade at a premium. Thus we see different prices for what are otherwise two identical securities. After a few weeks go by, the current on-the-run bond is replaced by the next issue and suddenly loses its liquidity premium. As long as the short position in on-the-run bonds is held until the next treasury auction, it yields a guaranteed gain when offset against the long position.

Source

I don't think that the profits that LTCM enjoyed by exploiting the on-the-run convergence trade should be thought of as arbitrage gains accruing as a result of other people's irrationality. Much like Asness & Liew and Kidde, LTCM was fabricating peace of mind for others; it held the illiquid securities others didn't want while borrowing and supplying the market with the liquid securities that others preferred. The "excess" return that LTCM enjoyed was the market's fair reward for providing this service.

The service that Asness and Liew provides also reminds me of what a bank does. A bank purchases illiquid personal IOUs issued by families and businesses while selling highly liquid deposits. The bank needn't offer much of an interest rate on deposits because deposits already provide a high liquidity yield. It requires a high interest rate on the IOUs it purchases because it must be compensated for absorbing their illiquidity. The spread the bank earns by holding illiquid assets and providing liquid assets is similar in nature to the HML spread earned by Asness and Liew, and the on-the-run/off-the-run spread earned by LTCM.

Of course LTCM eventually bit the dust. But that didn't have anything to do with the demise of the convergence trade, it had to do with leverage. When its debtors proved unwilling to roll over LTCM's funding, the fund was forced to liquidate at a loss before its positions had converged. If LTCM had been less aggressive, it could have easily held its positions until payoff. The firm might still be in the business of producing fire extinguishers for the financial community, just like Asness and Liew are doing by participating in the HML trade.