The reasons some investment anomalies have staying power are varied and surprising.
The academic literature is filled with challenges to the efficient markets hypothesis. Perhaps the greatest among these challenges involves the existence of momentum and the poor performance of small-growth stocks and high-beta stocks.
Beta is defined as the measure of the systematic risk of a security or a portfolio in comparison to the market as a whole. It’s highly correlated with another measure of risk—volatility.
Among the behavioral explanations for these two anomalies are that investors aren’t perfectly rational, that they don’t learn or change their behavior, and that there are some with a preference for assets with lotterylike distributions.
Assets with lotterylike distributions are those that exhibit positive skewness. That means most of the returns are distributed to the left of the mean, and also that the returns to the right are much further from it. These challenges exist because, even after the discovery of the anomaly becomes well known, they continue to persist.
Academic research has tried in various ways to explain why these anomalies can continue to survive. Among the possible explanations is that there’s a limit to arbitrage, which prevents rational investors from exploiting the anomaly. For example:
- Many institutional investors (such as pension plans, endowments and mutual funds) are prohibited by their charters from taking short positions.
- Shorting can be expensive. Investors doing so have to borrow a stock to go short, and many stocks are costly to borrow because the supply available from institutional investors is low. The largest anomalies tend to occur in small stocks—which are costly to trade in large quantity, both long and especially short—when the volume of shares available to borrow is limited and when borrowing costs are often high.
- Investors are unwilling to accept the risks of shorting because of the potential for unlimited losses. Even traders who believe that a stock’s price is too high know that they can be correct—the price may eventually fall—but also that they face the risk the price will go up before it goes down. Such a price move, requiring additional capital, can force traders to liquidate at a loss.
A 2010 study by Malcolm Baker, Brendan Bradley and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” proposed that another explanation might be at work: the typical institutional investor’s mandate to maximize the ratio of excess returns relative to a fixed benchmark without resorting to leverage.
Many institutional investors who are in a position to offset an irrational demand for risky assets have fixed benchmark mandates that are typically capitalization weighted, thus straying from the benchmarks to exploit anomalies creates career risk.