Swedroe: Default Risk Doesn’t Pay

December 07, 2015

The authors also note that the disposition effect can reduce liquidity in loser stocks and increase trading costs, making it more difficult for arbitrageurs to correct mispricings. In their study, Godfrey and Brooks present evidence showing that high credit risk stocks tend to be disproportionately owned by disposition investors. And disposition investors tend to be individuals, not institutions.

Research has found that institutional investors have a tendency to divest stocks that undergo declines in creditworthiness. Since individual investors are more prone to exhibit the disposition effect, the implication is that high credit risk stocks will be held disproportionately by disposition investors. Importantly, the disposition effect can help explain negative momentum, as disposition investors only slowly react to negative information.

Findings from the study “The Disposition Effect and Underreaction to News” by Andrea Frazzini, published in the August 2006 issue of The Journal of Finance, provide supporting evidence. Frazzini found that “bad (good) news travels slowly among stocks with large unrealized capital losses (gains), generating large subsequent returns for the overhang spread portfolio. Post-event returns of the negative overhang spread are not significantly different from zero. When negative news hits securities trading at large paper losses, it generates a severe post-event drift. Similarly, subsequent returns are large for positive news stocks trading at large gains.” In other words, the disposition effect helps explain momentum in stocks.

Limits To Arbitrage

Clifford Asness, Andrea Frazzini and Lasse Pedersen—authors of a 2012 paper, “Leverage Aversion and Risk Parity”—provide some valuable insights into the limits-of-arbitrage problem.

They write: “Assuming that some market participants are unable or unwilling to use leverage is not unrealistic. Leverage simply presents a risk that investors want to be compensated for bearing. Further, to obtain and manage leverage requires the acquisition of a certain ‘technology.’ Indeed, obtaining leverage requires getting financing, using derivatives, and establishing counterparty relations. Managing leverage requires, among other things, adjusting margin accounts and trading the portfolio dynamically over time, among other things. Our capital markets offer plenty of examples of investors that are not allowed (or choose not) to use leverage to increase their returns. For example, the majority of mutual funds and many pension funds are not allowed to borrow or are limited in the amount of leverage they can take. In addition, mutual fund families typically provide suggested asset allocations for low- to high-risk-tolerant investors. The high-risk recommendations rarely use leverage but, rather, suggest a very high concentration in equities.”

There’s another risk of shorting that should not be overlooked. While losses from being long are limited to 100% of your investment (assuming no leverage), losses from shorting are unlimited.

The Evidence

Godfrey and Brooks used the stock universe of all U.K.-domiciled stocks, active and dead, whose primary listing is or was on the London Stock Exchange Main Market or the Alternative Investment Market from June 30, 1987 through April 30, 2012. The authors chose the U.K. market because the U.K. has bankruptcy laws more favorable to creditors than those of the United States. Thus, U.K. equity holders typically expect to make a negligible recovery in bankruptcy resolution processes.

The pricing model they used included market beta, size, value and credit risk (using the well-known z-score, which measures the likelihood of default). They also examined the impact of illiquidity, turnover, momentum and bid/offer spreads. Following is a summary of their findings:


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