Swedroe: When False Factors Are Exposed

June 20, 2016

  • For both the annual and quarterly versions of the anomalies, trading with the anomaly was profitable in the original in-sample period. The alpha of the equally weighted portfolio was 1.54% per quarter.
  • Consistent with the findings of the aforementioned study by McLean and Pontiff, the decay in raw returns in the period after publication was an average of 1.05%, a 32% reduction. Using the Fama-French three-factor model, there is a reduction in nine of the 14 anomalies. Interestingly, the momentum premium (which is purely behavioral-based) actually showed a small increase in the post-publication period.
  • In the in-sample, prior-to-publication period, institutional investors don’t 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 funds with high turnover.
  • There is a significant negative relationship between institutional trading and future anomaly returns in the ex-post portfolio (the portfolio based on the aggregate ranking of all published anomalies). 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.

Increasing Challenges For Active Managers

In our book, “The Incredible Shrinking Alpha,” Andrew Berkin and I provide evidence showing there are four major themes behind the trend toward a persistently declining ability for active managers to generate true risk-adjusted alpha. One of these four explanations is that academic research continues to uncover anomalies that have generated alphas in the past.

The study by Calluzzo, Moneta and Topaloglu provides evidence demonstrating that by publishing the findings on factors that provide premiums, academic research converts what once was alpha into beta (or loading on a common factor that investors can easily access through low-cost and passively managed funds). This has a negative impact on the ability of active managers to generate future alpha. In addition, through the process of arbitrage, the premiums also tend to shrink, creating further hurdles for generating alpha.


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

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