Andrew Clark of Thomson Reuters outlines how to measure liquidity effectively and understand what impacts it, and looks at changes in the way people are viewing liquidity post-2008.

Date: Mar 2012

Tags: Liquidity, Equities

• In terms of measuring liquidity, many people use volume, transactions and other similar measures – however, these only work because a floor is chosen
•  Large-cap stocks don’t tend to be as volatile, so their liquidity doesn’t often fall in terms of the volume and value of their shares which are traded
• An illiquid stock is is not necessarily a bad thing for an investor to hold – the issue is whether the investor is getting a higher return for that stock, given that it will take longer to sell
• People often get two things wrong with liquidity: first is the price impact, secondly is the use of the bid-ask spread

In terms of measuring liquidity, Andrew Clark said in an interview that many people use volume, transactions and other similar measures.

However, he said that these don’t actually measure liquidity – they mostly work because a floor is chosen.

An example might be where no stocks smaller than a certain market capitalisation are included, often small- and mid-cap stocks. However, said Clark, these tend to be liquid stocks by definition already.

As a result, investors should be careful to assess the common methods of determining liquidity.

What affects or skews liquidity

In times of market turbulence, Clark said large-cap stocks don’t tend to be as volatile, so their liquidity doesn’t often fall in terms of the volume and value of their shares which are traded.

The bigger issue in terms of skewing liquidity relates to small-cap stocks, he explained. The common measures such as volume and transactions won’t be captured here because some people use these numbers and divide them by market capitalisation. Yet they aren’t going to catch the fact that small-cap stocks become less liquid in more volatile times.

As a result, Clark said such stocks might not belong in an index or in an investor’s portfolio.

Impact of crises on views of liquidity

An illiquid stock is is not necessarily a bad thing for an investor to hold, said Clark. The issue is whether the investor is getting a higher return for that stock, given that it will take longer to sell.

The issue with emerging and frontier markets, however, is that investors don’t tend to get such a premium for less liquid stocks, he said.

Neither is this the case in the US, he added, where the liquidity premium for illiquid stocks has shrunk to almost zero. The consequence is that investors shouldn’t want to hold illiquid stocks.

Misconceptions with liquidity

According to Clark, people often get two things wrong with liquidity. First is the price impact, meaning that people want to be able to sell a stock at a price which won’t move the market, but this is difficult to evaluate, he explained.

The other thing is that people use the bid-ask spread, said Clark. The problem here is that this tends to work better if people are selling small lots of small-cap stocks, but if they are selling big lots of large-cap stocks, it cannot be used.