Is Market Necessarily More Efficient in Liquid Stocks? Evidence from the Distress Anomaly

Chuan Yang Hwang is currently a professor of finance and the director of the PhD program at Nanyang Business School, Nanyang Technological University. Professor Hwang holds a PhD from UCLA. Before joining Nanyang Technological University, he taught at University at California at Irvine, University of Pittsburgh and Hong Kong University of Science and Technology. Professor Hwang has published articles in leading finance journals such as the Journal of Finance, the Review of Financial Studies, and the Journal of Financial and Quantitative Analysis. His research interests are investment and corporate finance. Some of his research has been featured in business publications such as the Wall Street Journal. Prof. Hwang's areas of expertise are investment and corporate finance. His current research works focus on information risk and distress risk.

We use the distress anomaly as a setting to investigate the relationship between liquidity and market efficiency. We document the counterintuitive result that market is less efficient in liquid stocks. A strategy of taking a long position on stocks in the low distress quintile and shorting stocks in the high distress quintile would earn a Fama-French three-factor adjusted return of 0.84% per month for illiquid stocks, while the same strategy would earn a significantly higher return of 1.86% per month for liquid stocks. While investors’ preference for the jackpot type of payoffs inherent in high distress stocks alone explains the distress anomaly of illiquid stocks, it cannot not explain the difference of the anomaly between   liquid and illiquid stocks. Earnings announcement tests show that the difference in better explained by the pricing errors resulted from favorite-longshot bias of noise traders. Our results support the view that there is greater noise trading in liquid stocks, which not only generates greater pricing errors in the distress stocks but also greater limits to arbitrage as described in Shleifer and Summers (1990) and Shleifer and Vishny (1997).