Financial research has uncovered many relationships between investment factors and stock returns. For investors, an important question is whether the publication of this research can impact the future size of factor premiums. Asking this question is crucial on two fronts.
First, if anomalies are the result of behavioral errors, or even investor preferences, and the publication of research into them draws the attention of sophisticated investors, it’s possible that post-publication arbitrage would cause the premiums to disappear.
Those seeking to capture these identified premiums could quickly move prices in a manner that reduces the return spread between assets with high and low factor exposure. However, limits to arbitrage, such as aversion to shorting, and its high cost, can prevent arbitrageurs from correcting pricing mistakes. And the research shows that this tends to be the case when mispricing exists in less liquid stocks, where trading costs are high.
Factor Return Decay
Second, even if the premium is fully explained by economic risks, as more cash flows into the funds acting to capture the premium, the size of the premium will be affected. At first, publication will trigger inflows of capital, which drive prices higher and thus generate higher returns. However, these higher returns are temporary because subsequent future returns will in turn be lower.
R. David McLean and Jeffrey Pontiff, authors of the January 2015 study, “Does Academic Research Destroy Stock Return Predictability?” re-examined 97 factors that had been published in tier-one academic journals and were only able to replicate the reported results for 85 of them. That the remaining 12 factors were no longer significant could have been due to a variety of reasons, such as incomplete details in the original paper or changes in databases.
They also found that, following publication, the average factor’s return decayed by about 32%.
Institutions Can Correct Anomaly Pricing
Paul Calluzzo, Fabio Moneta and Selim Topaloglu contributed to our understanding of how markets work and become more efficient over time (the adaptive markets hypothesis) with their December 2015 study, “Anomalies Are Publicized Broadly, Institutions Trade Accordingly, and Returns Decay Correspondingly.” They hypothesized: “Institutions can act as arbitrageurs and correct anomaly mispricing, but they need to know about the anomaly and have the incentives to act on the information to fulfill this role.”
To test their hypothesis, they studied the trading behavior of institutional investors in 14 well-documented anomalies. I identify and explain those anomalies in my October 2016 blog, “Published Results Impact Future Results.” Note that many of them are either specific examples of well-known investment factors or are explained by those factors.