Alterations in the Liquidity Premium as an Effect of Exchange Traded Funds : A Study Performed on Nasdaq Composite between 1997 and 2016

Abstract: Investors have historically demanded a return premium for taking on the risk of illiquidity both in terms of characteristic and systematic liquidity risk. Recent research have presented results suggesting that the liquidity premium is diminishing. The increasing popularity of passive investments such as Exchange Traded Funds (ETFs) have been proposed as a driving force for the declining trend. Despite the popularity of ETFs, there is limited research how they impact the financial markets. The purpose of this thesis is to investigate how the liquidity premium has developed in the United States between 1997 and 2016 and to explore if developments in the liquidity premium can be linked to the capital inflow to the United States ETF market. The thesis uses measures of stocks’ spreads and order book depths as proxies for the characteristic and systematic liquidities. The proxies are used to test if liquidity has influenced stock returns over 1-year, 5-years and the entire 20-year period. The empirical results obtained through Fama-MacBeth regressions show that the liquidity premium can fluctuate by both sign and magnitude year by year. The characteristic risk premium is negative and significant for the entire 20-year period and the 1-year regressions suggests a clear negative trend. The systematic liquidity premium on the other hand is positive and significant for the entire 20-year period but the 1-year regressions do not show a clear trend. The empirical results show no statistical significance that ETFs influence the liquidity premium. However, the graphical interpretation of the 1-year regressions suggests that the characteristic liquidity premium is negatively correlated with the growth of ETFs. The negative characteristic premium implies that investors are not being adequately compensated for the risk of illiquidity and should therefore avoid a liquidity-based investing strategy which has generated excess return in the past.