With MiFID II approaching this January, market liquidity is a concern, a report from Morgan Stanley notes. So how does liquidity impact factor investing? Brian Hayes and his quantitative research team at the investment bank broke down how liquidity factors impacted stock price performance, discovering some regional and factor category differentials that provides a roadmap to enhanced entry and exit points. But it also revealed that under certain circumstances liquidity does not play a part in rising or falling factor performance.
Factor investing: Liquidity does not impact the US to the same degree as it does other global regions
Considering market capitalization and quantitative factors in a stock category – based on market cap, but also growth, value, momentum, for instance – the study yielded mixed results. In certain sectors, liquidity did not play a major role in price direction but in other areas it did.
When considering market capitalization in the US, stock market volume, used as a proxy for liquidity, “average returns were not significantly different in low vs non-low days,” the report stated. “.For the US, average cohort performance does not appear to be different in low liquidity periods.”
The US, however, is different than other regions where factor performance models show a more pronounced returns profile based on liquidity.
In Europe, Canada and Latin America, there was a different pattern of performance based on market capitalization. In general, large cap stocks underperformed on low volume days while small cap stocks outperformed, sometimes significantly. Mid-cap stocks, meanwhile, showed no discernible pattern relative to low or high volume days.
One generalization that held true was that across all regions and market capitalization categories was that low volatility exhibited a significantly high correlation with low volume. Morgan Stanley explains:
Low volume days may lack catalysts that could drive cheap stocks to rebound (or expensive stocks to sell off): we have observed that market volatility is lower in low volume days, and this may be a reflection of the lack of events/data on these days. Alternatively, investors may not be interested in taking a risk on value stocks in low volume days, as there is generally viewed to be a risk premium associated with value stocks.
Volatility, largely defined by a market surprise, often involves high trading volume because it can signal a market turn. Separately, numerous algorithms use volatility as a trigger to establish or exit positions, which adds to market volume during volatile periods.
While price performance of stocks based on market capitalization had a varying impact, when stock factors were considered, the impact took a decidedly different tack.
Factor investing: Growth and sentiment factors outperform on low volume days
December and August are notorious for its low trading volumes. “In addition, there are concerns of some investors that the start of MiFID II regulations on January 3, 2018 may reduce the liquidity in shares of both European and non-European stocks, due to elimination of Dark Pools, possible tick size changes, increased transparency and reporting requirements and general uncertainty about market structure,” Morgan Stanley opined.
With lower trading volumes impacting large and small cap stocks in Europe particularly, other factors might find a benefit in such a market environment.
Over the entire time period Morgan Stanley studied, from 1992- Oct.2017, growth and investor sentiment factors are most effective when trading volume is low. Meanwhile, valuation factors tend to outperform in the opposite market environment.
The report noted on days when trading volume is modestly or moderately low numerous momentum factors along with factors related to earnings revisions “dominate” among the list most effective factors. Meanwhile, on days when volume is extremely low capital structure/financial leverage factors are important in addition to growth/investor sentiment factors.
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