Research Brief: Liquidity Fragility

In this brief, we examine liquidity in arguably one of the most liquid equity markets in the world: The Standard & Poor’s 500 (S&P 500). Whereas the overall index is highly liquid, not all issues within the index are equally liquid. We examine where in the S&P 500 liquidity exists and where it is constrained.

One measure of liquidity is the cost to execute a given trade. When trading in size, the largest component of execution cost is market impact. Market impact of a security is a function of the liquidity demanded and the risk of the security. We utilize a simple transaction cost model to measure which S&P 500 names would potentially have experienced the largest market impact resulting from ETF flows in the last week of June 2015.

As liquidity is consumed by ETFs, or otherwise, certain risks can be magnified. Short-term price reversal is often a risk factor that is controlled for, or managed, by many investors. As a result, we examine the impact of short-term price reversal on the level of liquidity (defined as turnover). We find that illiquid stocks are more subject to a price reversal. Thus, investors should be wary of those stocks with low turnover in periods of high ETF flows or during a liquidity shock.