Financial research has uncovered many anomalies (mispricings) that persist even well after they’ve been discovered, the findings are published and their existence becomes widely known. The most well-known anomalies that represent violations of the Fama-French three-factor model (market beta, size and value) are:
- Net Stock Issues: Net stock issuance and stock returns are negatively correlated. It’s been shown that smart managers issue shares when sentiment-driven traders push prices to overvalued levels.
- Composite Equity Issues: Issuers underperform nonissuers, with “composite equity issuance” defined as the growth in the firm’s total market value of equity minus the stock’s rate of return. It’s computed by subtracting the 12-month cumulative stock return from the 12-month growth in equity market capitalization.
- Accruals: Firms with high accruals earn abnormally lower average returns than firms with low accruals. Investors overestimate the persistence of the accrual component of earnings when forming earnings expectations.
- Net Operating Assets: The difference on a firm’s balance sheet between all operating assets and all operating liabilities, scaled by total assets, is a strong negative predictor of long-run stock returns. Investors often focus on accounting profitability, neglecting information about cash profitability, in which case, net operating assets (equivalently measured as the cumulative difference between operating income and free cash flow) captures such a bias.
- Asset Growth: Companies that grow their total assets more earn lower subsequent returns. Investors overreact to changes in future business prospects implied by asset expansions.
- Investment-to-Assets: Higher past investment predicts abnormally lower future returns.
- Distress: Firms with high failure probability have lower—rather than higher—subsequent returns.
- Momentum: High (low) recent (in the past year) past returns forecast high (low) future returns over the next several months.
- Gross Profitability Premium: More-profitable firms have higher returns than less profitable ones.
- Return on Assets: More profitable firms have higher expected returns than less profitable firms.
Each of these anomalies is a puzzle for financial theory and a problem for the efficient markets hypothesis, because they don’t have risk-based explanations, which raises the question: Why do these anomalies persist even after they have been discovered and the findings are published?
Why Anomalies Persist
The financial theory for why anomalies can persist well after they become widely known is that limits to arbitrage exist that prevent rational investors from being able to exploit them. 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. You have to borrow a stock to go short, and many stocks are costly to borrow because the supply of available stock from institutional investors is low (they tend to underweight these stocks). The largest anomalies tend to occur in smaller stocks, which are costly to trade in large quantities (both long and especially short), the volume of shares available to borrow is limited and 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 a stock’s price is too high know that they can be correct (the price may eventually fall), but they still face the risk that the price will go up before it goes down. Such a price move, requiring additional capital, can force the traders to liquidate at a loss.
- There are other limits as well, including leverage (ability to borrow), transaction costs and, for taxable investors, taxes.