| Summary: | The Fama-French (FF) five-factor model is cast into a dynamic setting to capture the impact of illiquidity over the phases of the business cycle on the returns of the passive FF twelve sector portfolios. We use two dynamic approaches, Kalman filtering and a recursive/rolling robust instrumental variables (IV) algorithm cast into a GMM framework, to determine time-varying alpha and beta estimates. Our principal result is that the Kalman filter approach supports the hypothesis that illiquidity is an important risk factor in a dynamic context. However, the only factor found to matter in the dynamic GMM approach is the market risk premium. Nevertheless, illiquidity may be prescient with respect to financial crises. Keywords: Illiquidity, Fama-French five-factor model, Kalman filter, Robust IV algorithm, JEL Classification: C58, G12
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