Liquidity-driven approach to dynamic asset allocation: evidence from the German stock market

Eduard Baitinger (), Christian Fieberg (), Thorsten Poddig () and Armin Varmaz ()

Financial Markets and Portfolio Management, 2015, vol. 29, issue 4, 365-379

Abstract: Fluctuations in market-wide liquidity may offer opportunities of earning illiquidity premiums. For the US stock market, an investment strategy that profitably exploits these market-wide liquidity fluctuations is proposed by Xiong (J Portf Manag 39(3):102–111, 2013 ), who focus on an in-sample analysis. In this article, we firstly replicate the liquidity-driven investment strategy of Xiong (J Portf Manag 39(3):102–111, 2013 ) for the German stock market showing that a successful harvesting of illiquidity premiums is possible as well. Secondly, we extend the study design of Xiong (J Portf Manag 39(3):102–111, 2013 ) in that we conduct a strict out-of-sample analysis. Our results show that the initial superior in-sample results drastically deteriorate in an out-of-sample framework rendering the practical application of the liquidity-driven investment strategy for the German stock market impossible. Lastly, we modify the rather static investment methodology by a novel approach in which the asset allocation responds flexibly to market-wide liquidity fluctuations. This modification leads to significant performance improvements. Copyright Swiss Society for Financial Market Research 2015

Keywords: Dynamic asset allocation; Liquidity; Amihud illiquidity measure; Liquidity risk; Investment strategy; Out-of-sample study; G11; G12; C32; C53 (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1007/s11408-015-0257-1

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