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Liquidity-Driven Dynamic Asset Allocation

Wed, 01 May 2013 06:47:59 GMT

A paper published in The Journal of Portfolio Management, 2013, 39 (3), pp 102-111, by James X. Xiong, Rodney N. Sullivan, and Peng Wang.

Quotation
We propose a model of portfolio selection that adjusts an investors’ portfolio allocation in accordance with changing market liquidity environments and market conditions. We found that market liquidity provides a useful “leading indicator” in dynamic asset allocation. Specifically, market liquidity risk premium cycles anticipate economic and market cycles. Investors can therefore act to avoid markets with low liquidity premiums, waiting to extract liquidity risk premiums when the likelihood of extracting a liquidity premium improves. The result, meaningfully enhanced portfolio performance through economic and market cycles, and is robust to transactions costs and alternate specifications.



Basically this article examines a portfolio strategy that buys stocks and sells bonds when the market is less liquid, thus enjoying a higher liquidity premium, this strategy outperforms a benchmark with equal weights on stocks and bonds by generating a higher sharpe ratio and positive alpha.

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