Swedroe: Arbitrage Capital Increases Market Efficiency

August 01, 2016

The hypothesis of an efficient market is based on the concept that informed, rational traders would arbitrage away any temporary deviations from “correct” prices. Thus, price efficiency depends upon the actions of arbitrageurs and the availability of arbitrage capital.

When arbitrage capital is plentiful, anomalies should be quickly eliminated. However, if capital is scarce or there are sufficient frictions (such as trading costs, regulatory constraints and borrowing costs), while anomalies may shrink, they can still persist.

Effects Of Arbitrage Capital Availability

Ferhat Akbas, Will Armstrong, Sorin Sorescu and Avanidhar Subrahmanyam, authors of the paper “Capital Market Efficiency and Arbitrage Efficacy,” which was published in the April 2016 issue of the Journal of Financial and Quantitative Analysis, contribute to the literature on market efficiency by exploring the premise that the availability of arbitrage capital varies over time, which results in dynamic variation in the predictability of cross-sectional stock returns.

The authors begin by measuring return predictability using the ex-post return performance of a “quant” strategy designed to trade on five capital market anomalies documented within the academic literature.

Their study covered the period 1991 (the earliest available date for mutual fund flows) through 2009, and five anomalies: momentum, profitability, value, earnings and reversal. They noted: “Some of these anomalies earn large paper profits, and have persisted out-of-sample indicating that it is a challenge to attribute them to data mining. Further, it is difficult to come up with a risk-based story consistent with many of the anomalies documented in the literature. This suggests that cross-sectional anomalies may, at least in part, reflect temporary inefficiencies in market prices.”

To measure the amount of available arbitrage capital, Akbas, Armstrong, Sorescu and Subrahmanyam used flows to mutual funds whose trades mirrored those of their quant strategy (abbreviated as “quant funds”).

They identified these quant funds by regressing the returns of all mutual funds on the returns of a quant strategy and then selecting those with the highest return correlation. They write: “The flows to quant funds act as a proxy for flows to arbitrage strategies where arbitrage capital is used to target temporary pricing inefficiencies and move stock prices toward efficient benchmarks.”

Additionally, the authors noted: “Periods marked by high arbitrage flows are periods during which markets are more efficient. These periods are likely to see a correction of cross-sectional mispricing, resulting in lower returns to the quant strategy in the future. Conversely, any mispricing that is present at the beginning of periods with low arbitrage flows will likely persist throughout the period. Thus, periods marked by lower flows will be followed by periods with higher cross-sectional return predictability, which will manifest in the form of higher returns to the quant strategy.”


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