Swedroe: Evidence Of Shrinking Alpha

October 06, 2017

Short-term drifts in stock (as well as bond, commodity and currency) prices have been well- documented in the academic literature. The fact that prices fully adjust to new information gradually, over time, rather than instantaneously, is a violation of the efficient markets hypothesis.

On the other hand, Andrew Lo’s adaptive markets hypothesis acknowledges that while the efficient markets hypothesis may not necessarily hold in the short run, it does predict that inefficiencies will self-correct over time as, post-publication, arbitrageurs exploit them. Thus, financial markets trend toward efficiency in the long run.

Adaptive Markets Evidence

Chan Wung Kim, Xiao Li and Timothy Perry, authors of the study “Adaptation of the S&P 500 Index Effect,” which was published in the Summer 2017 issue of the Journal of Index Investing, provide us an interesting test of Lo’s adaptive markets hypothesis.

Research from the 1970s and 1980s had found economically and statistically significant abnormal returns (of about 3%) in the stocks newly added to the S&P 500 Index (by the committee) on the first day of trading following the announcement (i.e., the effective date). To reduce order imbalances on the day when the S&P 500 was changed, Standard and Poor's began pre­announcing additions in 1989.

As a result, the announcement of an addition led to price increases in the days prior to the effective change in the index. The anomalous behavior of upward price drifts resulted in positive abnormal returns that could be exploited by short-term traders.

What has been termed the “S&P game” arises because institutional fund managers whose portfolios track the index, to reduce the risk of tracking error, wait to rebalance their portfolios until the change is actually effective. A similar, though much greater, problem had occurred when the Russell 2000 was reconstituted (Russell has taken some steps to reduce that effect).

Persistent Anomaly

After the 1989 change, research showed that, between 1989 and 2001, additions to the S&P 500 Index were experiencing large positive abnormal returns (between about 6% and 9%) in the period between the market’s close on the announcement date and the market's close on the effective date. Interestingly, this anomaly persisted despite the problem being well-documented in the literature—contrary to the adaptive markets hypothesis.

It’s also contrary to the findings of Paul Calluzzo, Fabio Moneta and Selim Topaloglu, who contributed to our understanding of how markets work and become more efficient over time (in other words, the adaptive markets hypothesis) with their 2015 study, “When Anomalies Are Publicized Broadly, Do Institutions Trade Accordingly?

The authors 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.” Their study, which covered 14 well-documented anomalies, found that, on average, there was a 32% relative reduction in returns post-publication.

Effects Of Academic Research

These findings were confirmed by R. David McLean and Jeffrey Pontiff, authors of the 2016 study “Does Academic Research Destroy Stock Return Predictability?” They, too, found that factor premiums fell, on average, 32% post-publication.

McLean and Pontiff re-examined 97 factors published in tier-one academic journals and were able to replicate the reported results for 85 of them. That the remaining 12 factors were no longer significant may be due to a variety of reasons, such as incomplete detail in the original paper or changes in a database.

They found that portfolios containing stocks that are costlier to arbitrage decline less post-publication. This is consistent with the idea that costs limit arbitrage and protect mispricing.


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