Liquidity commonality and return co-movement

We show that liquidity commonality is due to co-movements in supply and demand induced by cross-sectional correlation in order types (market and limit orders), while return commonality is caused by correlation in order flows (order direction and size). Since return and liquidity commonality are caused by different economic forces, it is possible for assets to have little return correlation but high liquidity commonality. Based on extensive simulations and empirical evidence using ASX data, we conclude that it is important to consider not only liquidity, which has been shown to be a priced factor, but also liquidity commonality in asset pricing applications.