(July 18, 2012) — Those investors that don’t run for the hills when fears of illiquidity circulate may be positioned to gain, according to an academic paper.
While illiquid stocks experience larger price declines relative to liquid stocks over a period of two months, the declines revert completely over the subsequent three months, according to the paper by professor Azi Ben-Rephael from Indiana University’s Kelley School of Business.
Over the longer-term, institutional investors, such as pension and sovereign wealth funds, have an advantage to benefit from a liquidity premium, as illiquid assets yield slightly more than liquid assets, according to the paper . Long-term investors are generally better off with illiquid assets. “In periods of uncertainty, investors such as mutual funds are often forced to sell illiquid assets driven by customer withdrawals,” Ben-Rephael told aiCIO.
On the other hand, longer-term investors will not sell as readily because they know that after around six months, the difference between liquid and illiquid assets will be nil, the author said.
According to the paper, illiquid funds underperform their peers by almost 9% over roughly two months, which is the main driver behind mutual fund investors’ withdrawing from such investments. During periods of market uncertainty, the demand for liquidity increases, with the increase in demand likely affecting both prices and holding positions of illiquid assets.
Meanwhile, the paper noted that mutual fund managers are forced to trade, creating a direct selling pressure that contributes to the decline in illiquid stocks prices.
“Due to data availability of prices and holding positions, the equity markets are a natural laboratory for understanding the broad aspect of the flight-to-liquidity phenomenon,” the paper said. “Naturally, the effect of liquidity on less liquid and more opaque markets is much stronger. Thus, our findings contribute to a broader understanding of flight-to-liquidity in the markets, and can be used to shed light on possible frictions in other, less liquid, markets.”
The paper continued: “We analyze the change in holding position of different groups of institutional investors. Ex-ante, it is hard to infer who will have an incentive to trade illiquid stocks. On one hand, some investors might have reasons to sell illiquid assets when market uncertainty increases…on the other hand, facing liquidation investors might decide to sell their liquid assets first.”