Financial research has uncovered many relationships between investment factors and stock returns. For investors, an important question is whether the publication of this research can impact the future size of factor premiums. Asking this question is crucial on two fronts.
First, if anomalies are the result of behavioral errors, or even investor preferences, and the publication of research into them draws the attention of sophisticated investors, it’s possible that post-publication arbitrage would cause the premiums to disappear. Those seeking to capture these identified premiums could quickly move prices in a manner that reduces the return spread between assets with high and low factor exposure.
However, limits to arbitrage, such as aversion to shorting, and its high cost, can prevent arbitrageurs from correcting pricing mistakes. And the research shows that this tends to be the case when mispricing exists in less-liquid stocks where trading costs are high.
Second, even if the premium is fully explained by economic risks, as more cash flows into the funds acting to capture the premium, the size of the premium will be affected. At first, publication will trigger inflows of capital, which drives prices higher and thus generates higher returns. However, these higher returns are temporary because subsequent future returns will in turn be lower.
Paul Calluzzo, Fabio Moneta and Selim Topaloglu contribute to our understanding of how markets work and become more efficient over time (the adaptive markets hypothesis) with their December 2015 study, “Anomalies Are Publicized Broadly, Institutions Trade Accordingly, and Returns Decay Correspondingly.” They 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.”
To test their hypothesis, they studied the trading behavior of institutional investors in 14 well-documented anomalies. Note that many of these anomalies are either specific examples of well-known investment factors or are explained by those factors. The 14 anomalies are: