Buying in bonds via QE has reduced the numbers in public hands. With fewer bonds in issue, it is perhaps unsurprising to see that daily turnover in the bond markets has reduced.However, despite the fact that QE has not been used to purchase equities, we are also seeing a similar effect in the mainstream stock exchanges too.
In part this may be caused by many corporates taking on extra debt because it is cheap, and using the capital to buy back their shares.
But this doesn’t explain the full pullback in equity market turnover with FTSE 100 volumes nearly half what they were five years ago.
Looking at the trends over a longer timeframe, it is clear that equity turnover prior to 2008 was abnormally high, rather than the current volumes being abnormally low.
The problem is that many fund managers have grown used to plentiful liquidity.
It’s convenient to be able to change portfolio positions near instantaneously as news flow comes through.
Falling volumes make it even more difficult to trade in some of the more illiquid stocks.
Even some mid cap stocks are quite tricky on occasions, and I have also heard some complain about transacting in the lower half of FTSE too at times.
The question on some lips is – will this lead to institutions reducing their weightings yet further in stocks that don’t have easy liquidity? However, I would suggest the question should be rephrased.
Does prioritising companies with plentiful liquidity dilute returns for clients? There is some great research published on this, which examines the relationship between market turnover and return in the US between 1971 and 2011.
It compared the return of stocks with broadly similar market capitalisations, split between the 25 per cent with the highest turnover and the 25 per cent with the lowest.
The conclusions are sobering.
Amongst the large cap stocks the return on the most liquid stocks was around 3 per cent per annum less than the less liquid large caps.
Source: FE Analytics
The data helpfully also covered other size bands.
The overall pattern is consistent, with the most liquid quartile of stocks generating significantly less returns than the least liquid quartile.
However, what is rather more interesting is that the return on the most liquid quartile stocks gradually reduces proportional to the smaller size bands.
Investing in the most liquid mid-caps delivers inferior returns to the most liquid large caps.
The trend is so adverse, that investing in the most liquid micro caps generates an annual return that is less than 2 per cent compared with over 11 per cent in large caps.
So for those fund managers who really prize market liquidity over everything else, it makes sense to restrict their investment universe to the largest stocks.
For those managers who have genuine conviction in their stock selection over the longer-term, the data highlights that there are extra returns for those investing in the stocks that are the less liquid.
In addition, the best strategy is investing on a multi cap basis.
Returns on the largest stocks are really good, but even better returns are made for those with the flexibility to invest across all the size bands.
What this data really highlights is that market liquidity is a costly luxury – whereas those who invest on a long term basis get better returns.
We all knew that already of course, although it’s reassuring to see it confirmed in academic research.
Gervais Williams (pictured at top of article) is manager of a range of funds at Miton, including the £377m CF Miton UK Multi Cap Income fund and £263m Psigma Income fund.
The former has a bias towards small and mid-caps, while the latter invests predominantly in large cap companies.
CF Miton UK Multi Cap Income has been one of the most successful fund launches of recent times, returning over 80 per cent since its launch in October 2011.
Performance of fund and sector since launch
Source: FE Analytics
The fund has already closed to new money, despite not yet attaining a three year track record.
