Systematic vs. Idiosyncratic Liquidity : Cross-section of Stock Returns

This paper decomposes firm-specific monthly-varying Amihud (2002) illiquidity measure into two components: (i) systematic illiquidity; (ii) idiosyncratic illiquidity. While there is a positive and significant relationship between systematic illiquidity and one-month-ahead stock returns, the observed relationship disappears when very small stocks are excluded. On the other hand, investors tend to underreact to idiosyncratic (il)liquidity. Hence, stocks with positive (negative) idiosyncratic liquidity generate positive (negative) subsequent returns. More specifically, high-low idiosyncratic liquidity strategy generates around 11% annualized value-weighted risk-adjusted return. Investor inattention, illiquidity, and sentiment-driven irrational investors are the main drivers of underreaction to idiosyncratic liquidity component