Limits to arbitrage - Rules and structure explain pricing anomalies

 

The limit to arbitrage is one of the most important concepts in finance next to arbitrage pricing. Arbitrage works in a world without frictions and constraints. If there are arbitrage opportunities, the first thing to think about is not market inefficiency or behavioral bias but market structures that can create barriers to effective arbitrage. 

Limitations, in general, can be caused by regulation, transaction costs, financing, lack of skill, and the lack of capital committed to arbitrage at any specific time. Many of these limits to arbitrage are focused on investment frictions or risks and not market structure or rules constraints. However, understanding institutions matter if a researcher wants to go down the path of looking for and exploiting price anomalies. 

Capital is constantly searching for the best return to risk and small deviation from equilibrium may not be enough to create a reason for capital to close an arbitrage gap. We are perhaps using the arbitrage term loosely. There are few true arbitrage opportunities. Capital has to be committed, financing has to be lock-in, and there has to be no competing similar opportunities. To understand the limits of arbitrage requires a strong institutional knowledge of market mechanics which often does not exist with academic researchers. 

A key issue faced with testing the limits of arbitrage is forming a comparison between an unconstrained versus constrained environment. This test of the limits of arbitrage based on institutional constraints has been elegantly presented in the paper, "The causal effect of limits to arbitrage on asset pricing anomalies" published in the October 2020 Journal of Finance. 

The authors use a novel approach to explore the limits of arbitrage for 11 pricing anomalies. Regulation SHO from the SEC relaxed the short sale constraint on stocks. The paper explains the details of Regulation SHO.  The key is that the changes in short sale rules allow us the compare before and after behavior and a comparison of those stocks with constraints and those without. Regulation, market rules, can create mispricing that would not exist otherwise. It is not a risk story or a behavioral story, but a story focused on market structure that drives mispricing. Remove the limits and the anomalies may disappear. The tables below summarize the main results of the work. 

It is harder to conduct equity arbitrage if you cannot effectively short a stock. Anomalies can continue for the simple reason that the arbitrageur cannot form a risk-free trade. Hence, those stocks which have short sale restrictions lifted will have the limit to arbitrage lifted. Pricing anomalies that existed before should disappear after the constraints are lifted. Similarly, since the short-side constraint was lifted, the excess returns from the anomaly should decline from the short-side of the trade. The researchers try this on a wide variety of strategies from momentum to return on assets. It does not change results in all cases, but a less constrained world is different. 

Mispricing driven by constraints, such short selling rules, is exactly what was found in this paper. When constraints are lifted, the out of the ordinary pricing that previously existed disappears. To trade in the real world, every researcher has to be an institutionalist.

Equity long/short and market neutral hedge funds - Can they improve in 2021?

The investment foundation for equity long/short or market neutral hedge funds is the manager having the ability to widen the opportunity set of choices. Long-only investing is limiting because, at best, poor companies can only be excluded from the set of opportunities. Long/short managers should have a decided advantage versus the long-only manager because they can both hold long and short positions and selectively decide to cut market exposure while still holding a set of attractive long positions. The market neutral manager can eliminate the market exposure and create a portfolio of firm-specific opportunities, a pure alpha opportunity fund. In theory, this widening of choice should be a great opportunity for both active managers who has skill and the investors who wants the broadest set of directional choices for their managers. 

Allowing managers to flex their skill over this broader opportunity set is the way these funds are marketed, yet in practice the results have been less compelling during this post GFC period. There can be a number of explanations for this failure, yet none have been studied too closely in order to provide definite answers. 

The explanation for low long/short or market neutral returns is wide-ranging. Clearly, if the long/short manager has a lower beta to the market their alpha production may not generate enough return to offset a one-way rising market. Alternatively, there is the view that competition in stock-picking may just be too great, so alpha has been eroded. Lower equity dispersion may have reduced the opportunities for stock picking. The classic value play used by many hedge funds managers has underperformed during this period. Small caps have not generated the expected premium seen in the past.

The current environment calls into question how managers are picking opportunities and whether there is active stock-picking or market timing skill by managers. Nevertheless, there are clear winners in this space, just not with the strategy averages. This discussion on the reason for a drag on performance is not about the great managers but the average manager represented in hedge fund indices. As measured by hedge fund indices of managers, performance has been strained relative to their skill at marketing. This is seen in 2020 and in the last year.

Nevertheless, there may be some hope for 2021. First, volatility has increased even with a decline from the highs in March. Second, stock dispersion has also increased versus earlier periods. Third, the overall market is considered overvalued which may allow short positions to profit. Overall, 2021 may be a better year through greater opportunities for shorting specific names and cutting market exposure. 

One man's investment diary through the Great Depression

 

Reading about the Great Depression can be a dry affair. Most investors only focus on a few highlights without spending much time on the details. That is unfortunate. The thumbnail sketch is simple. There was a stock market crash, bank failures, severe unemployment, and then the New Deal solved the problem. Bad Fed decisions and tight money failed the banking sector and economy. For many, activist government policies worked, and the doors were opened to the Keynesian revolution.

Most investors spend even less time thinking through the social impact on consumers and the fear faced by those trying to make investment decisions during this uncertain period. Banks closed and businesses shuttered without warning.  There are some good books describing the social impact from the Depression, and there have been recent revisionist books on the “forgotten man” impacted by the downturn and policy choices, but little has been written about what investors were thinking during this period. 

I jumped at the chance to read about investor perceptions when I recently heard about the book The Great Depression: A Diary, published in 2009. What makes this a good read is the sense of uncertainty that was felt by the author as he walks through the financial ups and downs during this traumatic time. 

The author, Ben Roth, was not a wealthy man but a middle-class lawyer during depression who has trouble collecting from clients and paying his bills. He had a strong interest in investments during this period and made regular diary entries describing his thoughts on the markets and the economic environment. He sprinkles sage investment advice in his entries that is useful even today. Roth describes the ups and downs of stocks, the economic climate in Youngstown, Ohio, and how crowds moved from optimism to pessimism and back again from 1929 until the beginning of WWII. 

Reading his views in real time is fascinating. He has hopes for Hoover after 1929 and concerns with the Roosevelt policies. He writes about bank failures, the inability to collect on bills from those with nothing to give, fortunes made and lost in a wild stock market, the bottom falling out on what was perceived as safe real estate, and the fear of just not knowing when the depression will end or whether the latest policies will actually work. Unemployment led to protests and unrest and it was not clear whether life savings could be withdrawn from banks. Without the support of hindsight, it becomes an interesting tale of how one man deal with financial unknowns.

This book is important because it creates a fearful tone that is often missing from history books. Economic fear is real, and it should not be missed that many are currently living in similar economic fear from the pandemic. Excessive fear will lead to actions that in another time would be viewed as irrational. Hence, we cannot always predict the actions of consumers or investors.

Animal spirits, declinism, and policy choices that will impact asset allocation

There will be significant work published on what should be the right asset allocation for 2021. I read as many of these pieces as I can get my hands on.  There is a simple question for US investors tied to these forecasts that moves beyond COVID and economic policies. Do you have optimist or pessimist view on US economic and political prospects beyond the COVID recovery?

Given the high level of uncertainty, this question can be phrased differently. Should you have positive animal spirits, as described by Keynes, to invest and spend even in an unknown world, or should you take a defensive posture based on economic weakness and US pessimism? 

Beyond the policy tactics of vaccines and lockdown reversals that will affect market expectations, investment allocations should be based on optimistic or pessimistic animal spirits and what is the process and policy choices that will get the economy to a more positive state. This positive state is tied closely with the broad political view of US declinism and pessimism concerning its preeminent status in the global economy and world affairs. The path for a correction to declinism will drive longer-term US optimism. (See "The China Challenge Can Help America Avert Decline: Why Competition Could Prove Declinists Wrong Again" in Foreign Affairs for a general discussion of declinism.)

  

For Keynes, markets are often driven by animal spirits, the optimism or pessimism that exists when the future is highly uncertainty. When uncertainty is high, the normal tools of valuation and analysis are ineffective. Investors just don't know and have to rely on their feeling of optimism or pessimism. In a depression or recession, pessimistic animal spirits drive decisions. A recovery occurs when sentiment changes to optimism. There is no question there is a current sense of financial optimism; however, this euphoria may not be matched in the real economy. More optimistic animal spirits will drive the US economy beyond catch-up to long-term growth. 

Declinism, the belief that the United States is sliding irreversibly from its preeminent status, has been a major theme of the last four year and will be the key theme for the next four years especially if there is a desire for stronger long-term growth. Declinism talk started much earlier but has swept into the general political discussion in more tangible and extreme forms of political choice.  

The declinism solution is centered between two extremes for policy. One position has been it can be arrested through unilateralism and a reversal of the liberal globalist order. The alternative position also believes declinism is caused by inequality and a lack of global cooperation that needs to be addressed through social and economic restructuring and the rule of international law and cooperation. Both argue for a change in the behavior and structure of the United States; nevertheless,  the choice of direction will impact the longer-term pricing of financial assets and the potential for sustained growth. 

Investor allocations will be making a choice on whether declinism can be reversed and the policy form necessary for the reversal. The success of risk-on asset allocation will be determined by the declinism solution accepted by the public and how that path forward will improve both the US and the global economy. Any end of declinism will be coupled with a sense of optimism that problems can be overcome and that investment will be rewarded and productivity enhanced; however, the policy choices will impact the form and placement of the optimism. Investor should consider alternative declinism solution paths.  

This discussion may be an abstraction, but sustained financial gains needs to be coupled with a robust economy that moves beyond a story of COVID recovery.