Sunday, February 1, 2015

Paper: "The Limits of Arbitrage"

This is an important paper [pdf] by Andrei Shleifer and Robert Vishny that's been cited over 3000 times. (Same authors, previously, on value vs glamour, principal-agent problems, and comparative investor rights/debt enforcement globally.)

Here are the highlights:

  • "Markets in which fundamental uncertainty is high and slowly resolved are likely to have a high long-run, but a low short-run, ratio of expected alpha to volatility. For arbitrageurs who care about interim consumption and whose reputations are permanently affected by their performance over the next year or two, the ratio of reward to risk over shorter horizons may be more relevant."
  • "As we argue in this article, the theoretical underpinnings of the efficient markets approach to arbitrage are based on a highly implausible assumption of many diversified arbitrageurs. In reality, arbitrage resources are heavily concentrated in the hands of a few investors that are highly specialized in trading a few assets, and are far from diversified. As a result, these investors care about total risk, and not just systematic risk."
  • "[I]n extreme situations, arbitrageurs trying to eliminate the glamour/value mispricing might lose enough money that they have to liquidate their positions. In this case, arbitrageurs may become the least effective in reducing the mispricing precisely when it is the greatest."
  • "The glamour/value anomaly is one of several that our approach might explain. The analysis actually predicts what types of market anomalies can persist over the long term. These anomalies must have a high degree of unpredictability, which makes betting against them risky for specialized arbitrageurs. However, unlike in the efficient markets model, this risk need not be correlated with any macroeconomic factors, and can be purely idiosyncratic fundamental or noise trader risk."
  • "[A]nomalies become understood very slowly and that investors do not take definitive action on their information until long after a phenomenon has been exposed to public scrutiny. The anomaly is more easily accepted when the pattern of returns is not very noisy and the payoff horizon is short (such as the small firm effect in January). A 'noisy' anomaly like the value-glamour anomaly is accepted only slowly, even by relatively sophisticated investors."

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