MARKET EFFICIENCY AND ANOMALIES
LOS 55.d: Explain why a mispricing may persist and why valid anomalies
There are several reasons that pricing anomalies can persist, but all are rooted in the
SEUdy Session 13
Cross-Reference to CFA Institute Assigned Reading #55 - Market Efficiency and Anomalies 1. Lack of Theoretical Explanation
If the reasons underlying a persistent pricing anomaly are not well understood, it is difficult to exploit. Arbitrageurs will use their funds to exploit other mispricings which they believe they understand better and are, therefore, better able to exploit and profit from.
2. Transactions Costs
The trades necessary to exploit any apparent mispricing may not be profitable because the costs of the trades are greater than the potential abnormal returns. Transactions costs include the bid-ask spread, brokerage commissions, and the impact that larger trades may have on the price of the securities involved. Mispricings of the stocks of smaller companies will be more likely to persist because the transactions costs for smaller firms' stocks will typically include higher percentage bid-ask spreads and higher costs from price impact of trades due to their lower liquidity.
3. Small Profit Opportunities
The total profit to be gained by exploiting a mispricing may be small enough that it does not represent a significant profit opportunity to large funds. Again, mispricings of the stocks of smaller companies may be persistent because the small size of the
positions that can be established limits the profits to be realized by exploiting the mlspnclllg.
4. Trading Restrictions
Restrictions on short selling make some strategies impossible for some period of time.
Note that when a stock is first offered to the public, it typically cannot be shorted immediately after the IPO since shares cannot be borrowed. Initial overpricing of a new IPO can persist for days because of traders' inability to short the shares.
5. Irrational Behavior
Investor tendencies of perception and analysis that run counter to rational trading and investing may lead to persistent mispricings that are not rapidly exploited by
arbirrageurs for one or more of the reasons we have noted thus far.
6. Other Limits on Arbitrage
The limits on arbirrageur activities previously discussed (e.g. limited capital, strategy risk, investor short-term performance demands) also can explain the persistence of some market pricing anomalies.
There may be valid anomalies (persistent, backed by theory, and not the result of measurement bias) that do not or will not result in profitable trading strategies. One reason for this is that evidence of mispricings is typically based on average returns for large samples over significant time periods. While there may be evidence that the market initially underreacts to positive earnings surprises, for any particular stock or time period there is no guarantee that purchasing a stock after a positive earnings surprise will result in positive returns or positive abnormal returns. A second reason that rrades based on valid anomalies may not be profitable is that even when abnormal
Study Session 13 Cross-Reference to CFA Institute Assigned Reading#55 - Market Efficiency and Anomalies returns (returns adjusted for risk and overall market performance) are positive, raw
(unadjusted) returns can be negative during periods of market decline.
A third reason that arbitrage based on valid anomalies may be unprofitable is that the conditions causing the mispricing may change. This is especially true when the accepted explanation for the anomalous pricing is not well understood or is mistaken.
In this case a change in the conditions that actually are causing the mispricing may not be recognized, so arbitrageurs are seeking to exploit a pricing anomaly that will not occur in the future.
A final reason that attempting to exploit a documented pricing anomaly may be unprofitable is the fact that arbitrage itself may have eliminated the associated mispricing. If enough investors purchase stocks after positive earnings surprises, the prices of these securities will rise to their efficient levels and the strategy of buying
"positive earnings surprise" stocks will no longer be profitable.
Study Session 13
Cross-Reference to CFA Institute Assigned Reading #55 - Market Efficiency and Anomalies
KEy CONCEPTS
1. Market prices are generated by the activities of researchers and traders who analyze and react to new information. There must be some reward for this effort, but that reward may be earned only by those who process and act on the new information rapidly and skillfully.
2. Transaction costs prevent trading and arbitrage from resulting in perfectly efficient securities prices. Securities and strategies with higher transaction costs permit greater deviations from perfectly eftlcient prices.
3. Information-based trading is not without risks. Arbitrageurs have no guarantee that prices will move to "more rational" levels or that strategies will consistently perform well, have limited capital, and constraints imposed on them by the suppliers of investment capital.
4. Research purportingto have identified anomalous returns behavior may be subject to data mining bias, incorrect measurement of risk and abnormal returns, small sample bias, survivor bias, sample selection bias, or the use of stale prices due to nonsynchronoustrading.
5. In addition to transactions costs and the inherent limitations of arbitrage, reasons why a mispricing may persist include a lack of a theoretical explanation for the anomaly, small size of the potential profit from exploiting it, trading restrictions, and irrational investor behavior.
6. Trading on anomalies may not be profitable because strategies that work on average may not be profitable in a particular case or during a broader market decline, the conditions causing the mispricing may change, or arbitrage may have eliminated the mispricing.
Study Session 13 Cross-Reference to CFA Institute Assigned Reading#55 - Market Efficiency and Anomalies
CONCEPT CHECKERS
1. The effect on market efficiency of restricting shorr sales is most likely to:
A. create a band of efficient prices.
B. improve market efficiency.
C. lead to upside bias in stock prices.
D. reduce the speed of adjustment to new information.
2. A researcher has examined the performance of the shares of firms that went public during the period 1998 to 1999 and found evidence of positive abnormal returns over the three months after the firms' shares began trading.
This evidence of anomalous returns behavior isleast likely subject to:
A. measurement problems for abnormal returns.
B. sample selection bias.
C. small sample bias.
D. survivorship bias.
3. A researcher has examined a sample of shares of smaller firms that trade infrequently and found that they have had greater volatility'of the price change between the market closing price and the opening price the next trading day than large-cap stocks in similar industries. Based on this information, he suggests entering into an options trading strategy to exploit the differences in overnight volatili ty. The researcher has most likely:
A. misestimated normal returns.
B. confused price change with volatility.
C. overestimated overnight volatility of his sample.
D. introduced small sample bias into his results.
Srudy Session 13
Cross-Reference to CFA Institute Assigned Reading #55 - Market Efficiency and Anomalies
1. C The best answer here is "lead to upside bias." The higher the transactions costs ofshon sales, the more security prices may be above efficient levels without causing shon sales to drive them down to efficient levels. This will not necessarily reduce the speed of adjustment to new informarion as much as it will limit adjustment when stocks are overpriced.
2. D The researcher has used a relatively small time period during which the post-initial public offering (IPO) returns of new issues may not have been representative of those over longer time periods. There is potential bias in the sample because the selection criterion may have produced a sample that is highly concentrated in one, or a few, industries that were experiencing unexpectedly rapid growth. Any time abnormal returns are being measured over longer periods, such as three months, there are potential measurement errors. Additionally, since the stocks had no trading history, estimating risk is problematic. There is no indication that the sample suffers from survivorship bias, since IPOs were included regardless of their fates.
3. C The estimating of normal rerurns is not an issue here and we have no information suggesting that his sample or sample period is necessarily small. The most likely problem here is one of nonsynchronous trading. For stocks that trade infrequently, market closing prices may be those from trades many hours earlier and the opening trades the next day may come many hours after the opening. The problem, then, is that he is measuring volatility over a potentially much longer period for the small-cap stocks than for the large-cap stocks that likely trade near both the close and the opening.
The following is a review of the Analysis of Equity Investments principles designed to address the learning outcome statements set forth by CFA Institute®. This topic is also covered in: