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

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 (JPortfManag39(3):102–111,2013)inthatweconductastrictout-of-sampleanalysis. 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.