Liquidity Trading Strategy

Illiquid securities trade at a discount relative to liquid securities to compensate investors for liquidity risk. The liquidity discount adjusts with changes in market liquidity conditions (i.e., changes in liquidity risk). When market liquidity conditions deteriorate, investors will demand an increase in the liquidity discount. Similarly, when market liquidity conditions improve, investors will require less of a liquidity discount. Therefore, illiquid securities will be expected to underperform liquid securities when market liquidity risk increases and will be expected to outperform when market liquidity risk decreases.

However, markets are slow in adjusting prices to changes in liquidity risk. Our trading strategy exploits this inefficiency. Moreover, its success demonstrates that our liquidity risk measurement is a leading indicator of future price movements.

The strategy seeks to long the Dow Jones Industrial Average (DJI) ETF (a proxy for a liquid portfolio) and short the Russell 2000 (RUT) ETF (a proxy for an illiquid portfolio) when market-wide liquidity risk is increasing. The strategy will short DJI and long RUT when market-wide liquidity risk is decreasing.

Trading Algorithm

The portfolio is re-balanced monthly

At the begining of each month, the market Liquidity conditions are clasified into two regimes using OGI's Market Illiquidity Level (MIL). Market Liquidity is considered to deteriorate if MIL shows an increase during the trailing quarter. Market Liquidity is considered to improve if MIL shows a decrease during the trailing quarter.

When market liquidity deteriorates, the strategy recommends taking a short position in liquidity risk for the current month. This is implemented using the following pair-trade:

• Long DJI ETF (more liquid portfolio)
• Short RUT ETF (less liquid portfolio)

When market liquidity improves, the strategy recommends taking a long position in liquidity risk for the current month. This is implemented using the following pair-trade:

• Short DJI ETF (more liquid portfolio)
• Long the RUT ETF (less liquid portfolio

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