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Liquidity and Systematic risk

Peter Bernstein in his article published in Journal of Portfolio Management speculates on the relationship between the liquidity and systematic risk.

The article seems to be based on the assumption that the liquidity is very closely correlated to systematic risk. This can be proved empirically and something traders experience day-to-day. Briefly, liquidity is the function of various macro-economic factors and hence would lead to a systemic impact.

Mr. Bernstien says, "How much research do you need to buy S&P500 index fund or futures as compared with research you would have to do if you wanted to pick and choose just a few among those five hundred stocks? No wonder the five hundred together are more liquid than any one or even ten of them - and in this case diversification comes along for the ride. No research!"

"More liquid the asset, more the liquidity means WYSIWYG. The value of all assets with so much similarity move up and down together because they are interchangable with one another." and hence "When it comes to most liquid kinds of assets such as money or treasury bills, liquidity and sytematic risk are one and the same. [emphasis in original]

In other words, if the liquidity is more, the impact the market forces has on the particular asset is more, and if the liquidity is less the systemic impact is less. Using the above, we can deduce, liquidity & specific-risk are two sides of the same coin (are inversely related). Hence as the degree of liquidity reduces for a particular asset the specific-risks for the asset increases, and hence the need for greater amount of asset specific research.

We may also deduce that (relative) out-performance [;)] is directly related to the liquidity in the asset.

On a lighter vein, in the periods of liquidity would be the period of easy money for those who are in right asset class. We do not require fund managers to outperform. We only have to watch the liquidity (policies/impact) in the system. Or as the street wisdom goes, high-tide raises all boats. But make sure you factor in the specific-risk so that you are not the one swimming naked when the tide goes out.


>> To be revised

:) Falkor
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