Swedroe: Published Results Impact Future Results

An exploration of what happens to factors once research is published on them.

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.

14 Anomalies

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:

1. Net Stock Issues: Net stock issuance and stock returns are negatively correlated. It has been shown that smart managers issue shares when sentiment-driven traders push prices to overvalued levels.
2. Composite Equity Issues: Issuers tend to underperform nonissuers, with “composite equity issuance” defined as the growth in a firm’s total market value of equity minus its stock’s rate of return. It is computed by subtracting the 12-month cumulative stock return from the 12-month growth in equity market capitalization.
3. 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.
4. 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 tend to 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.
5. 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.
6. Investment-to-Assets: Higher past investment predicts abnormally lower future returns.
7. Distress: Firms with high failure probability have lower, rather than higher, subsequent returns.
8. Momentum: High (low) recent past returns forecast high (low) future returns.
9. Gross Profitability: More profitable firms have higher expected returns than less profitable ones.
10. Return on Assets: Again, more profitable firms have higher expected returns than less profitable firms.
11. Book-to-Market: Firms with high book-to-market ratios have higher expected returns than firms with low book-to-market ratios.
12. Ohlson O-Score: Stocks with a high risk of bankruptcy have lower returns than stocks with a low risk of bankruptcy.
13. Post-Earnings Announcement Drift: The tendency for a stock’s cumulative abnormal returns to drift for several weeks (or even several months) following release of a positive earnings announcement.
14. Capital Investment: Firms that substantially increase capital investments subsequently achieve negative benchmark-adjusted returns.

Portfolio Results

To determine if investors exploit these anomalies and help bring stock prices closer to efficient levels, Calluzzo, Moneta and Topaloglu constructed portfolios from them that were long stocks with positive expected returns and short stocks with negative expected returns. The study covered the period January 1982 through June 2014. Following is a summary of their findings:

• For both the annual and quarterly versions of the anomalies, trading with them was profitable during the original in-sample period. The alpha of the portfolio equally weighted across each of the anomalies was 1.54% per quarter.
• Raw returns in the period after publication decay to an average of 1.05%, a 32% relative reduction. Using the Fama-French three-factor model, there is a reduction in nine of the 14 anomalies.
• During the in-sample, prior-to-publication period, institutional investors did not take advantage of stock return anomalies.
• In the post-publication period, institutions trade to exploit the anomalies. The net change in aggregate holdings (the change in the long leg minus the change in the short leg) is positive.
• Partitioning institutional investors into hedge funds, mutual funds and others, the results are strongest among hedge funds, and then among actively managed mutual funds with high turnover.
• There is a significant negative relationship between institutional trading and future anomaly returns in the ex-post portfolio. Institutional trading after anomaly publication is related to the post-publication decay in anomaly returns.
• There is a significant increase in trading by hedge funds in the period just before publication, suggesting that hedge funds have knowledge about the anomalies prior to journal publication (likely through presentations at conferences or from postings on the Social Science Research Network).

The authors concluded: “Institutional trading and anomaly publication are integral to the arbitrage process, which helps bring prices to a more efficient level.” Their findings demonstrate the important role that both academic research and hedge funds (in their role of arbitrageurs) play in making markets more efficient.

Further Evidence

What Calluzzo, Moneta and Topaloglu found is consistent with research from R. David McLean and Jeffrey Pontiff, authors of the January 2016 study “Does Academic Research Destroy Stock Return Predictability?” McLean and Pontiff re-examined 97 factors that had been published in tier-one academic journals and were only able to replicate the reported results for 85 of them. That the remaining 12 factors were no longer significant could be due to a variety of reasons, such as incomplete details in the original paper or changes in databases.

They also found that, following publication, the average factor’s return decays by about 32%. Note the agreement of that figure with the one found in the Calluzzo, Moneta and Topaloglu paper discussed earlier, and that returns don’t decay to zero, but remain positive.

In addition, the authors found factor-based 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. As the authors note: “Decay as opposed to disappearance will occur if frictions prevent arbitrageurs from fully eliminating mispricing.” They also found that “strategies concentrated in stocks that are more costly to arbitrage have higher expected returns post-publication. Arbitrageurs should pursue trading strategies with the highest after-cost returns, so these results are consistent with the idea that publication attracts sophisticated investors.”

Two conclusions can be drawn from this research. First, anomalies can persist even when they become well-known. McLean and Pontiff write: “We can reject the hypothesis that return predictability disappears entirely, and we can also reject the hypothesis that post-publication return predictability does not change.”

Second, research does appear to lead to increased cash flows from investors seeking to gain exposure to the premiums, which in turn leads to lower future realized returns. However, note that where logical, risk-based explanations exist, premiums should never disappear. For example, no one expects the market beta premium to disappear even though it has been well-known for decades. However, investors shouldn’t automatically assume that future premiums will be as large as the historical record.

International Evidence

Heiko Jacobs and Sebastian Muller contribute to the literature on returns to anomalies with their July 2016 study, “Anomalies Across the Globe: Once Public, No Longer Existent?” Their study covered the pre- and post-publication return predictability of 138 anomalies in 39 stock markets that account for, on average, almost 60% of the global equity market capitalization and more than 70% of the global GDP. The data covered the period January 1981 to December 2013.

While their findings for the United States were similar to those of the aforementioned study by McLean and Pontiff, showing declining premiums, none of the 38 international markets yielded a significant post-publication decline in anomaly returns. In fact, the authors found that returns to anomalies in international markets actually had increased—equally (value) weighted returns rose from 34 (28) basis points between 1981 and 1990 to 56 (40) basis points between 2001 and 2013. Following is a summary of their findings:

• Averaged over the entire sample period, long/short anomaly returns in various subsets of international markets turn out to be similar in magnitude to estimates for the U.S. market.
• Many anomalies tend to be a global phenomenon and thus are unlikely to be driven mainly by data mining.
• In almost every country, equally weighted portfolios generate greater returns than value-weighted portfolios. This is consistent with the notion that both mispricing and limits to arbitrage tend to be stronger for smaller stocks.
• For the majority of countries, pooled long/short returns are statistically significantly positive at the 1% level.
• There are large differences between the U.S. and international markets with respect to subperiods in both calendar time (i.e., time trends) and in event time (i.e., publication effects).

Jacobs and Muller concluded that, while their findings do point to a strong negative time trend, as well as to increased postpublication arbitrage trading in the United States, they did not find reliable evidence for an arbitrage-driven decrease in anomaly profitability in international markets.

In addition, they found that differences in standard arbitrage costs “seem to explain at best a fraction of the large differences … post-publication.” Jacobs and Muller added that they explored “several possible mechanisms behind the surprisingly large differences between the return dynamics in the U.S. and international markets” but were “unable to fully explain the results.”

They write: “Our findings are consistent with the idea that sophisticated investors learn about mispricing from academic studies, but then focus mainly on the U.S. market.” They end with the following: “Our results may thus be interpreted as a puzzle that calls for further theoretical and empirical investigation.”

Summary

The academic research has found that, at least in the United States, institutions do trade to exploit anomalies post-publication, with hedge funds and actively managed mutual funds being the most aggressive in this pursuit. The research also demonstrates we can reject the hypothesis that return predictability disappears entirely. But while premiums do not disappear, in the United States, they do experience a decay in magnitude of about one-third.

What is more, portfolios of costlier-to-arbitrage stocks decline less post-publication. This is consistent with the idea that costs limit arbitrage and protect mispricing. That said, outside of the United States, the evidence suggests that anomalies, and the size of their related premiums, have not been impacted as of yet. And that may present opportunities in terms of portfolio strategy.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.