Liquidity of Large Stocks

Small-Cap Illiquidity

Gunner's Note: For today's Sleuth, we once again turn to Satya Dev Pradhuman, director of Small-Cap Research at Merrill Lynch and author of Small-Cap Dynamics. In this essay, Pradhuman addresses one of the biggest concerns when it comes to investing in small caps -- the liquidity. You see, small-cap stocks tend to have few shares -- meaning just a little bit of buying can push prices higher.

As you'll discover, that's led to a myth that small caps don't really outperform other stocks -- it just seems that way because of artificial price hikes. Of course, Pradhuman presents proof that this idea is all wet.

So enjoy today's essay. And if you want to check out more of Pradhuman's ideas, check out his book here...

The Sleuth
Liquidity of Large Stocks
September 25, 2006

The illiquidity of smaller stocks is the most credible argument against the existence of a small-cap premium and perhaps the one most difficult to dismiss... [It's true,] small companies can be extremely illiquid. Active small-cap investments are therefore unlikely to replicate simple benchmark or historical results. Because the large-cap benchmarks are several times more liquid, however, active large-cap investment results are more likely to be representative of the historical data.

This argument suggests that the historical paper-based benchmark performance results, as seen in popular indices such as the Russell 2000 or the Merrill Lynch Small Cap Composite, are perhaps several hundred basis points above actual investment returns. Remember that benchmarks such as the Russell 2000 and S&P 500 are simply paper-based calculations of stock prices as they are quoted on the exchange. The price of a stock can differ significantly, depending on how liquid the stock is, as investors attempt to make a purchase. The mathematics is sound; if the average bid-ask spread of a small firm is 2 percent, then one needs to subtract at least 2 percent from the annualized rate of return for small stocks.

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The effect of liquidity on the small-cap premium is more complex, however. For instance, index funds based on the small-cap market can achieve performance results, adjusted for costs, not unlike those of their popular paper-based benchmarks. If trading costs were as prohibitive as is suggested by the simple trading-cost argument above, an index tracking effort would be unlikely to match its intended target. Nonetheless, as research has shown, passively managed small-cap funds can nicely match their paper-based benchmarks. In a study of the U.S. small-stock market, Rex A. Sinquefield noted that the success of passive funds was primarily dependent on the managers' attention to trading costs. With respect to the United Kingdom small-cap market, Elroy Dimson and Paul March, professors of finance at London Business School, found that the Hoare Govett Small Cap Index Investment Trust, an index fund that tracks that market, exhibited a tracking error of 1.46 percent and underperformed its benchmark by only an annualized 0.37 percent per annum in 1993-98.

Based on the illiquidity of small stocks, active small-cap managers might be expected to lag their benchmark results relative to their large-cap counterparts. Yet a look at active performance data suggests otherwise. Compared to large-cap investors, a greater proportion of active small-cap managers tend to outperform their benchmarks. [The following table] compares the proportion of small-cap funds that outperformed their benchmark to the proportion of large-cap active funds over most of the 1990s.

It is notable that the higher transaction costs associated with small stocks do not appear to significantly hinder the abilities of small-cap active investors. Ultimately, this edge exhibited by small-cap managers is compelling evidence that smaller stocks are less efficiently priced, and, as a result, allow investors to generate above-average results.

Even though trading costs can represent significant barriers to entry, it is possible that simple bid-ask spreads appear wider than the actual realized trading results of small-cap funds. One explanation is that when a fund is fully invested, the fund manager can keep turnover to a manageable level. Investors need not completely overhaul their portfolios on a regular basis. Because trades would occur only on an opportunistic basis, the portfolio would never be completely sold to make room for new candidates.

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Another factor may be that liquidity is a primary issue in the trading function. Trading is always a competitive factor in the investment business, but it is especially relevant in small-cap management. A small-cap investor can benefit significantly from trading a stock that is racing to new highs. The relative illiquidity of the stock can cause its price to jump more dramatically than the price of a more liquid stock, which allows its holders to benefit from the positioning of the trade. As a result, a small-cap stock that is trading higher is likely to benefit its holders more than a large-cap idea that has similarly appreciated. A skillful small-cap trader might thus have more of a competitive advantage than a similarly talented large-cap trader.

Finally, it is also possible that the simple bid-ask spreads might represent an overly difficult trading environment faced by investment advisers. After all, the small-cap market contains many dormant investments that have collapsed. In those situations, trading may be nonexistent, and the spreads measured may be unusually wide. Simple aggregate small-cap statistics reflect not only the hundreds of stocks that normally trade but also the shares that have fallen off the beaten path.

Greater Scale of Large Stocks

The incredible bull market that began in the late 1990s has forced the money management industry to rethink its core business strategy. When millions of dollars are entering the equity market on a daily basis, managers need to be concerned about efficiently getting those funds invested. The profitability of an asset management firm lies in the fees generated from the assets it manages. If a firm can more easily grow assets through large-cap products, which can rapidly increase the assets being managed, the firm is likely to hold a more favorable disposition toward large-cap investing.

This creates a difficult setting for investment managers who need to grow assets but are investing in more thinly traded securities. Creating a position in blue chips can be accomplished in a seamless manner, but attempting to place, into smaller stocks, one-tenth of the assets one might place in a large-cap fund can be a challenging task. Proponents of the big-cap bias are quick to claim that the need to invest sizable dollars continues to force the average money management firm to migrate toward large-cap products. This argument creates, in some respects, a new motivation to invest in large stocks.

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The liquidity benefits of large stocks are compelling; they suggest that swings in favor of large caps can become accentuated. However, investors ultimately care more about performance than efficiency. Investment managers are rewarded or penalized according to the degree to which their performance varies from the rest of the pack or from the benchmark. This variation typically is measured in mere basis points. Unless investors change the basis of distinguishing a good manager from a marginal performer, the liquidity and scale factors of large stocks are unlikely to create a new paradigm of investing.

Satya Dev Pradhuman is the Director of Small-Cap Research at Merrill Lynch and was ranked the #1 small company analyst for the year 2000 by Institutional Investor Magazine. He has also served as a quantitative analyst focusing on small-cap and midcap equity and equity derivatives at Merrill Lynch, and has held positions in research at E.F. Hutton and Lehman Brothers. Ranked in the top echelon of small-cap analysts by Institutional Investor and Reuters, Pradhuman is often sought out and has been cited in leading publications such as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, and has appeared on CNN, CNBC, and The Nightly Business Report.