The authors note: “Decay, as opposed to disappearance, will occur if frictions prevent arbitrage from fully eliminating mispricing.” They also write that “strategies concentrated in stocks that are costlier to arbitrage have higher expected returns post-publication.”
Returning to Kim, Li and Perry’s study, stocks in the S&P 500 Index are not costly to arbitrage. Thus, the anomaly should have disappeared. Yet it persisted long after publication. With the adaptive markets hypothesis in mind, the authors extended the research to include the period from 2010 through 2013.
They found that, on average, a newly added stock's abnormal return between the market’s close on the announcement date and the market’s close on the effective date was now just a statistically insignificant 97 basis points (p-value of 0.33).
S&P 500 Effect Diminishing
Importantly, they also no longer found any evidence of price drift from the open on the day following the announcement to the close on the effective day. They did find, however, that the return between the close on the announcement date and the open on the following morning is a statistically significant 3.09%. In other words, the overnight return is similar to what was found in prior studies of earlier periods.
This is consistent with markets having incorporated new information instantly. They also found no evidence of an exploitable price drift from the open on the day following the announcement to the close on the effective day. The return gap from the open on the day following the announcement to the close on the effective day is a statistically insignificant 42 basis points.
Moreover, the authors found that “the return from the open to the close on the day following the announcement is a statistically significant negative 55 basis points!”
Diminishing S&P 500 Effect
Kim, Li and Perry concluded: “We find no evidence of a positive price drift between the announcement day and the effective day for stocks added to the S&P 500. Additionally, we find little evidence of a meaningful positive return associated with index inclusion.” They add: “The S&P 500 effect is diminishing (and will possibly disappear eventually).”
Their findings not only offer support for the adaptive markets hypothesis, but provide another example of what my co-author Andrew Berkin and I called “The Incredible Shrinking Alpha.” The “S&P game” once provided a rich source of alpha for hedge funds and actively managed mutual funds.
But as we show in our book, sources of alpha are disappearing as academics convert what once was alpha into beta (a common factor or trait) and arbitrageurs incorporate the latest findings. That’s why, 20 years ago, 20% of actively managed funds were generating statistically significant alpha, while today that figure is about 2%, and shrinking.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.