May 23, 2011
Is there a liquidity risk factor in stock returns that helps explain differences in average returns?

EFF/KRF: There are academic papers that address this question. Some papers say that the differential exposures of stocks to a liquidity risk factor account for differences in average returns. We are far from convinced. The problem is that exposures to this risk factor are estimated quite imprecisely. They look like statistical (random) noise, and noise can't be the source of real differences in expected returns. (You can't explain something with nothing.) From a more practical perspective, if estimated exposures to a risk factor are just statistical noise, they cannot be used to improve investment decisions.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.