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.
These limits to arbitrage allow mispricings to persist, and in turn, delay the flow of wealth from irrational investors (generally thought of as “dumb” money) to sophisticated investors. That’s the theory, anyway.
Yongqiang Chu, David Hirshleifer and Liang Ma, authors of the January 2016 paper “The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies,” contribute to the literature through studying the causal effect of limits to arbitrage on the 10 anomalies listed above.
Their study employs a Securities and Exchange Commission (SEC) experiment, Regulation SHO, to identify the causal effect of limits to arbitrage; in particular, short-sale constraints, on asset pricing anomalies. Regulation SHO was adopted by the SEC in July 2004. The Regulation SHO pilot program removed short-sale restrictions on a randomly selected group of stocks.
The Effects Of Regulation SHO
For stocks within the Russell 3000 Index as of June 2004, Regulation SHO removed the “uptick rule” (a short sale could only be made on an uptick) for a subset of NYSE/AMEX equities. Regulation SHO designated every third stock ranked by trading volume on the NYSE and AMEX (as well as the Nasdaq) as pilot stocks.
Pilot stocks were exempted from the uptick rule or the bid price test from May 2, 2005 to August 6, 2007. The program made it easier to short-sell pilot stocks relative to nonpilot stocks. Thus, this period provided an ideal setting to examine the causal effect of short-sale constraints on asset pricing anomalies.
To test the limits to arbitrage hypothesis, for each asset pricing anomaly, the authors constructed long-short portfolios with pilot and nonpilot stocks. Specifically, they sorted pilot firms into deciles according to variables that predicted cross-sectional returns, and then calculated the anomaly returns as the return differences between the highest-performing decile (the long legs) and the lowest-performing decile (the short legs). They then applied the same methodology to all nonpilot stocks. Following is a summary of their findings:
- The anomalies are much weaker in long/short portfolios constructed using pilot stocks during the pilot period.
- The effect is statistically significant in four of the 10 anomalies. When the 10 anomalies are combined in a joint test, the effect is both statistically and economically significant.
- Regulation SHO reduces the anomaly returns in the joint test by 77 basis points per month, or 9.24% per year. The results were highly statistically significant.
- The returns of short-leg portfolios constructed with pilot stocks were significantly higher during the pilot period—short strategies became less profitable. In contrast, there is no significant effect of the pilot program on long-leg portfolios. This is consistent with the existence of limits to arbitrage. It’s also consistent with other research that finds most of the anomalies are explained by the short side.
- The difference in short-sale restrictions between pilot and nonpilot stocks disappears after Regulation SHO ends in August 2007, and the difference in anomaly returns between pilot and nonpilot portfolios also vanishes.
- The effect of easier short-selling on anomalies is more pronounced among small and less-liquid stocks, a finding that is consistent with the limits to arbitrage hypothesis.
- The results remain intact after adjustment for the CAPM and the Fama-French three-factor model—in each case, they were both economically significant and highly statistically significant.
Constraints Affect Asset Prices
The results clearly show that the pilot program of Regulation SHO, which reduced the impact of limits to arbitrage, also reduced the size of the mispricings in hard/costly-to-short stocks. The authors conclude: “These results show that limits to arbitrage and short sale constraints play an important role in generating the ten well-known anomalies, and suggest that these anomalies are, at a minimum, driven in substantial part by mispricing.”
The bottom line is that these findings add further weight to an already-large body of evidence from the field of behavioral finance showing that short-sale costs/constraints impact asset prices, thus allowing these anomalies to persist. Investors can benefit from this knowledge by directly avoiding the purchase of stocks with well-known anomaly characteristics or by investing in long-only funds that screen out such stocks.
A final note: In March 2011, the SEC adopted amendments to Regulation SHO. Among the rule changes is SEC Rule 201 (Alternative Uptick Rule), a short-sale-related circuit breaker that, when triggered, will impose a restriction on prices at which securities may be sold short. The SEC has also issued guidance for broker-dealers wishing to mark certain qualifying orders “short exempt.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.