A large body of evidence demonstrates the persistence of numerous anomalies in stock prices, which suggests they can depart from fundamentals for periods of time. The anomalies include:
- Failure Probability: Stocks with a high probability of failure have lower future returns.
- O-score: Stocks with higher O-scores (a higher probability of bankruptcy) have lower future returns compared with stocks with lower scores.
- Net Stock Issuances: The stocks of firms that issue equity underperform the stocks of nonissuers.
- Composite Equity Issuance: Firms with higher equity issuance underperform firms with lower measures.
- Accruals: Stocks with high accruals underperform stocks with low accruals.
- Net Operating Assets: Stocks with higher net operating assets underperform stocks with lower net operating assets.
- Momentum: Stocks with higher past performance outperform stocks with lower past performance.
- Gross Profitability: Stocks with higher gross profitability have higher future returns.
- Asset Growth: Stocks with higher asset growth have lower future returns.
- Return on Assets: Stocks with higher return on assets have higher future returns.
- nvestment-to-Assets: Stocks with higher past investment (scaled by total assets) have lower future returns.
Evidence that these anomalies persist indicates so-called smart money is not fully able to erase mispricings, which are created by “dumb money.” The persistence of these anomalies—despite the large number of hedge fund strategies that trade on various anomalies documented in the academic literature—is a significant puzzle.
Limits To Arbitrage
As anomalies became common knowledge, we would expect them to vanish. However, the “limits-to-arbitrage” literature provides several explanations for why the anomalies may not completely vanish:
- 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 supplies of available stock from institutional investors are low. The largest anomalies tend to occur in small stocks (which are costly to trade in large quantity, both long and especially short) because the share volume available to borrow is limited and borrowing costs are often high. In other words, market frictions prevent prices from being fully corrected.
- 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 they can be correct in the long term (the price may eventually fall), but still face the risk that the price will go up in the short term before it eventually goes down. Such a price move, requiring additional capital, can force the traders to liquidate at a loss.
Ferhat Akbas, Will Armstrong, Sorin Sorescu and Avanidhar Subrahmanyam, authors of “Smart Money, Dumb Money, and Capital Market Anomalies,” which appears in the November 2015 issue of the Journal of Financial Economics, contribute both to the literature and to our understanding of why anomalies occur and persist even after their discovery.
They used flows into retail mutual funds as a proxy for “dumb money,” and flows into hedge funds as a proxy for “smart money.” Their use of these proxies is based on the findings in the literature, which include:
- Retail investors tend to “chase performance” by directing money to mutual funds with strong recent performance while failing to redeem capital from funds with poor recent performance.
- Retail investors tend to direct “dumb money” to mutual funds that hold overvalued stocks.
- When mutual fund managers receive new flows from retail investors, they usually increase positions in existing stock holdings. As a result, net money inflows are associated with higher contemporaneous returns and subsequent return reversal.
- High-performing mutual funds tend to attract relatively higher flows, which are then reinvested by fund managers into their existing stock holdings. Similarly, mutual funds with poor performance tend to liquidate existing holdings to meet redemptions. Price pressure from the purchases of recent winners (or liquidation of recent losers) causes return continuation (helping explain the momentum anomaly).