Monday, October 31, 2005

Is long run IPO underperformance driven by lack of liquidity?

Is Long-run IPO underperformance driven by lack of liquidity?

What a roll! Maybe it is time to talk about momentum blogging! ;) Yet another cool paper!

Roychoudhury and Abbott tie long run underperformance of IPOs (See Ritter 1991 or Loughran and Ritter 1994) to a lack of liquidity (the Amihud and Mendelson 1986 idea).

In Roychoudhury and Abbott's own words:
"We construct portfolios of IPOs with positive and negative excess liquidity during the first year after IPO issue. While overall we find IPO underperformance in the long run, we show that positive and negative excess liquidity portfolios perform differently. We show that positive excess liquidity portfolio underperforms the negative excess liquidity portfolio during next few years. We show that the above effect holds for portfolios constructed in the event time and in calendar time, for equally weighted and value weighted portfolios, and for size or industry benchmarks....Our result has significant implications about the role of observed
liquidity as an indicator of future returns."
To dive in a bit deeper:

* The paper "support[s] the contention that portfolios of more liquid stocks on average provide investors with significantly lower returns than more illiquid stock portfolios even after adjusting for risk. We find IPOs underperform in the long run even after the accounting for liquidity, industry, size, market and year effects."

* The paper uses two measures of liquidity: the so-called standard "spread" based measure as well as a new measure Lambda which is based on turnover and price. Again in the authors' words (see the paper for a more detailed description!)
"lambda is a measure of the observed level of liquidity, with higher levels signifying that the current order flow in the market can absorb larger volumes of trading without impacting prices."
Cool paper! I can not wait to see what this does to other "anomalies" and even pricing models in general! (come on CAPM ;) )

"Revisiting Liquidity Underperformance: Excess liquidity Effect"
(Upload date: Oct 10, 2005) Saurav Roychoudhury and Ashok Bhardwaj Abbott.

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