Is Illiquidity a Risk Factor? A Critical Look at Commission Costs

A quarterly time series of the aggregate commission rate for NYSE trading over 1980–2003 allowed an investigation of the information conveyed by this liquidity risk metric and analysis of its critical role in the generation of stock returns. The aggregate commission rate was found to be highly correlated with other illiquidity metrics, such as the bid–ask spread. The rate is significantly and positively related to the excess returns of the stock market portfolio and has significant explanatory power for the cross-sectional variation in stock returns. An analysis of size-based portfolios indicates that returns become more sensitive to the aggregate commission rate with declining market capitalization.Knowledge of market microstructure has grown explosively in recent years. Important insights on such topics as limit-order placement strategy for intraday trading, the choice between an automated or floor trading system, and the link between the pricing of IPOs and the activity of secondary-market dealers are of interest to portfolio managers and investment advisers.A topic with considerable relevance to practitioners is the role of liquidity as a factor in asset pricing and portfolio risk. The market microstructure literature suggests that trading costs reflect asymmetric information and market liquidity. One study showed that expected returns are an increasing function of illiquidity. Illiquidity, as measured by bid–ask spreads, commands higher expected returns to compensate for the higher transaction costs investors incur in a less liquid market. Significant changes in asset values have been documented when assets are moved from a less liquid trading system to a more liquid one. Recently, researchers have suggested that liquidity is an important marketwide risk factor in pricing stocks. Holding illiquid financial assets involves nondiversifiable risk, and traders demand premiums for taking such risk. Therefore, variation in liquidity may be closely associated with varying expected returns.In this study, we developed a reliable quarterly time series of the aggregate commission rate for NYSE trading for the period 1980–2003. We show in the article that the aggregate commission rate exhibits a strong correlation with the other frequently studied illiquidity metrics. We document a strong and positive relationship between aggregate stock returns and commission costs. And we demonstrate a significant cross-sectional relationship between betas associated with the aggregate commission rate and average returns.The impact of the aggregate commission rate on market returns survived a number of robustness checks in our study and was found to be significant both statistically and economically. Using 10 size-based portfolios, we show that a statistically significant annualized liquidity premium associated with going long the smallest-capitalization portfolio and shorting the largest-cap portfolio is 2.02 percentage points, which suggests that the relationship between time-series betas on the commission rate and the cross-sectional difference in asset returns is not only statistically significant but also economically important. Our results also show that a change of 1 standard deviation in the illiquidity factor corresponds to a 4.68 percentage point change in quarterly aggregate market returns.Cross-sectional variation in expected returns among securities arises because of differences in trading costs. The aggregate commission rate exhibits significant explanatory power for the cross-sectional variation of average returns, after traditional asset-pricing factors have been controlled for. We found that the sensitivities of returns of size-based portfolios to marketwide liquidity risk are significant and decrease with increasing size of the stock in the portfolios. Our results show that an increase of 1 standard deviation in the illiquidity factor is associated with a 3.08 percentage point increase in the spread between the returns of the portfolios of the smallest-cap and the largest-cap portfolios, after the market, value versus growth, and momentum factors have been controlled for.For hedge fund managers who take advantage of mispriced securities and other marker inefficiencies, our study provides compelling evidence that transaction costs should be accurately accounted for in a successful trading strategy. Our findings support the hypothesis that marketwide liquidity is an important risk factor and significantly affects expected returns.