With these articles, I usually stick to the larger picture. There are many big ideas investors should know about. These usually allow for analogies and interesting stories/examples. Today I wanted to dive into something a bit more technical.

Recently, several members of Dimensional's research team published a paper titled Reversals and the Returns to Liquidity Provision. That link will bring you to the paper itself, while here leads to a short discussion regarding the paper's main findings.

In short, stocks that have very recently soared tend to do worse in the short-term and vice versa. The paper shows the link between a company's liquidity and the size/speed of the reversal.

This is an interesting effect, which runs counter to what we know about momentum. Over less than a month, a stock which has done exceptionally well will tend to do worse in the coming weeks. This is a reversal. However, stocks that have done well for a quarter or so tend to do well for the next few quarters. This is momentum.

The reason for the seemingly contrary results lies in the underlying causes. Momentum is easy to understand. A rising share price following new information tends to last for some time. Reversals, on the other hand, are symptomatic of how markets operate to provide liquidity.

Often when we trade individual stocks, we aren't buying and selling directly to other individual investors. "Market makers" sit in the middle, buying large amounts of shares and selling them later to other investors. This keeps markets moving so investors don't have to wait long periods or face big discounts when unloading shares.

Market makers don't do this for free. Like how banks must charge more interest on loans than they pay on deposits, market makers pay slightly less than the market rate when buying and receive slightly more when selling. This is how they are compensated for keeping things running.

Understanding this explains why a stock's price would reverse after a big move. A large bundle of purchases require market makers to step in and they ask slightly more than the market price. The market price later drops when they offload shares to investors.

The paper above showed how the liquidity of a company affects this trend. The less a share is traded, the higher the amount market makers "charge" for providing liquidity. This leads to a bigger change in prices and a more rapid change.

Sure, this is somewhat interesting, but what does it actually mean for us?

Dimensional's overall strategy revolves around diversifying across the whole market, while carefully tilting towards, small, value and profitable companies. By focusing on long-term drivers of returns, they can minimise the costs of trading.

These factors, momentum and reversals, are very short term. While a value companies take about 7 years on average to deliver their expected surplus returns, a reversal happens over a month. Momentum happens over 9 months. Making a strategy based around these factors means buying big lots of shares only to get rid of them months later. Sounds expensive!

But when we have portfolios containing 8,000 different companies, these findings are not going to waste. While they are not adopted at the top level of the strategy, they are useful at the trading stage.

Every day, Dimensional is studying the prices of all holdings in their funds. For example, when a company grows from a small company into a large company, it's expected return drops. This triggers a sell flag for the portfolio managers. All of these flags are sent to the trading team, who may have a list of a dozen different companies.

At this stage, the trading team will evaluate which of these companies to buy/sell. Here is where these other factors come in. If the share price has shot up over the past month, it is more likely to experience a reversal, so maybe they will pass on that company. Others may have gone up over 3 months, indicating a momentum effect. This company is more appealing than others on the list.

All of these considerations show how research can be applied to deliver better funds to investors. Although new papers will rarely shake the foundations of the investment world, each discovery adds new considerations for how trading should be undertaken. We are confident in Dimensional, who continue to lead the industry in new research and efficient applications for clients.