Investments, tenth edition

  The Neglected-Firm Effect and Liquidity Effects   

Arbel and Strebel  

27

   gave 

another interpretation of the small-firm-in-January effect. Because small firms tend to be 

neglected by large institutional traders, information about smaller firms is less available. 

This information deficiency makes smaller firms riskier investments that command higher 

returns. “Brand-name” firms, after all, are subject to considerable monitoring from insti-

tutional investors, which promises high-quality information, and presumably investors do 

not purchase “generic” stocks without the prospect of greater returns.

 

 As evidence for the    neglected-firm  effect,       Arbel  

28

   divided firms into highly researched, 

moderately researched, and neglected groups based on the number of institutions hold-

ing the stock. The January effect was in fact largest for the neglected firms. An article 

by Merton  

29

   shows that neglected firms might be expected to earn higher equilibrium 

returns as compensation for the risk associated with limited information. In this sense the 

neglected-firm premium is not strictly a market inefficiency, but is a type of risk premium.

 

 Work by Amihud and Mendelson  

30

   on the effect of liquidity on stock returns might be 

related to both the small-firm and neglected-firm effects. As we noted in Chapter 9, inves-

tors will demand a rate-of-return premium to invest in less-liquid stocks that entail higher 

trading costs. In accord with this hypothesis, Amihud and Mendelson showed that these 

stocks have a strong tendency to exhibit abnormally high risk-adjusted rates of return. 

Because small and less-analyzed stocks as a rule are less liquid, the liquidity effect might 

be a partial explanation of their abnormal returns. However, this theory does not explain 

why the abnormal returns of small firms should be concentrated in January. In any case, 

exploiting these effects can be more difficult than it would appear. The high trading costs 

on small stocks can easily wipe out any apparent abnormal profit opportunity.