Have capital market anomalies attenuated in the recent era of high liquidity and trading activity?

Highlights

• We examine if capital market anomalies have attenuated in recent years.

• These years have been accompanied by significant liquidity increases.

• We find that the majority of the anomalies have attenuated.

• Returns to anomalies have approximately halved after decimalization.

• Thus, policies to increase liquidity stimulate market efficiency.

Abstract

We examine whether the recent regime of increased liquidity and trading activity is associated with attenuation of prominent equity return anomalies due to increased arbitrage. We find that the majority of the anomalies have attenuated and the average returns from a portfolio strategy based on prominent anomalies have approximately halved after decimalization. We provide evidence that hedge fund assets under management, short interest and aggregate share turnover have led to the decline in anomaly-based trading strategy profits in recent years. Overall, our work indicates that policies to stimulate liquidity and ameliorate trading costs improve capital market efficiency.

Introduction

Recent years have witnessed a sea change in trading technologies and the costs of transacting in capital markets. Chakravarty et al. (2005) and French (2008) document the significant decline in institutional commissions. Technology has facilitated algorithmic trading (Hendershott et al., 2011) and hedge funds have proliferated. The improvements in trading technology and liquidity are dramatic and quite unprecedented.¹ Chordia, Roll and Subrahmanyam (CRS) (2011) show that these phenomena have been accompanied by an explosion in trading volume; the monthly, value-weighted average share turnover on the NYSE increased from 5% in 1993 to 35% in 2008, whereas it was virtually unchanged in the 1970s and 1980s. CRS also present evidence that it is institutional trading volume that accounts for this increase and that this increased volume is associated with improvements in market quality.

In this paper, we investigate the economic notion that increased liquidity in recent years should have stimulated greater anomaly-based arbitrage and thus attenuated capital market anomalies. Our analysis is related to the recent strand of research that investigates whether increases in liquidity and trading activity are associated with greater efficiency.² We empirically explore how the Fama and MacBeth (FM) (1973) cross-sectional coefficient estimates and the decile-based hedge portfolio returns have changed over time due to increased liquidity, and, in turn, increased arbitrage activity.

The literature on cross-sectional return predictors is vast. Ball and Brown (1968) document the post-earnings-announcement-drift (PEAD) where stocks with a high earnings surprise continue to outperform stocks with a low earnings surprise. Jegadeesh (1990) and Lehmann (1990) document short-term reversals in stock returns. Fama and French (1992) document the size and the value effect. Returns are negatively related to firm size and positively to the book-to-market ratio. Jegadeesh and Titman (1993) uncover the momentum effect wherein buying past winners and selling past losers lead to substantial abnormal returns. Sloan (1996) investigates the accruals anomaly where stocks with greater non-cash components of earnings earn lower abnormal returns. Ang et al. (2006) document that stocks with high idiosyncratic volatility earn lower returns than stocks with low idiosyncratic volatility. Cooper et al. (2008) show that stocks with higher asset growth have lower returns than those with lower asset growth. Fama and French (2006) and Pontiff and Woodgate (2008) document the impact of profitability and new equity issuances, respectively.

Some of the above anomalies, such as earnings drift and momentum earn large paper profits, and have persisted out-of-sample long after their discovery (Bernard and Thomas, 1989, Rouwenhorst, 1999, Kothari, 2001), indicating that it is a challenge to attribute them to data mining. Further, it is difficult to come up with a risk-based story consistent with so many anomalies. This suggests that the anomalies may, at least in part, be arbitrageable. But, arbitrage, by its very nature, makes anomalies unstable, and subject to attenuation. This argument implies that the prevalence of anomalies may decline as secular increases in liquidity, trading activity, and technological trading innovations facilitate arbitrage. This is the motivation for our analysis.

In our sample, most anomalies are statistically significant for both NYSE/AMEX (NYAM) and Nasdaq stocks. However, most of the hedge portfolio returns and the FM coefficients attenuate towards zero over time. We conduct additional analysis to identify the reason behind the attenuation of the anomaly profits. Specifically, we try different identification schemes, including (i) the decrease in the tick size due to decimalization, (ii) the impact of hedge fund assets under management (AUM), (iii) the impact of the aggregate short interest, and (iv) aggregate share turnover. All of above variables are proxies for arbitrage activity.

The decrease in the tick size (and the bid-ask spread), due to decimalization, proxies for a reduction in trading costs that might have led to increased arbitrage activity. We find that the characteristic premiums (i.e., FM coefficients) of virtually all anomalies have attenuated from before to after decimalization, and the average returns as well as the Sharpe ratio from a comprehensive anomaly-based trading strategy have more than halved after the shift to decimal pricing. Further, the impact on returns of several anomalies, including momentum, accruals, idiosyncratic volatility, and earnings surprises, as well as the profits to a comprehensive portfolio trading strategy, has declined with an increase in hedge funds׳ AUM, short interest, and/or aggregate trading activity, indicating a link between arbitrage proxies and attenuation in anomalies. These results are consistent with the informal arguments of Schwert (2003) who, in reviewing anomalies documented during the 1970s and 1980s, suggests that increased arbitrage activity should limit the persistence of such anomalies.

A recent study by Fama and French (2008) explores various cross-sectional return predictors and finds that the most robust anomalies are those associated with momentum and accruals. Further, Korajczyk and Sadka (2004) explore the cross-sectional relation between momentum and trading costs. Our work adds to these studies by focusing on the trend in cross-sectional predictability. Specifically, we explore the notion that as trading technologies improve, anomaly-based predictability should diminish, both statistically and economically. Our results are broadly consistent with the economic notion implicit in Fama, 1965, Fama, 1970 that technologies that reduce trading frictions and stimulate arbitrage facilitate market efficiency.³

A number of recent papers examine issues similar to those explored in our paper. Thus, other recent work (e.g., Schwert, 2003, McLean and Pontiff, 2013) has also examined sets of anomalies and their profitability over time. With regard to individual anomalies, Mashruwalla et al. (2006) discuss how liquidity can attenuate anomalies (the accruals anomaly in particular).⁴ Green et al. (2011) argue that the decline in profitability of the accrual based trading strategy is due to an increase in capital invested by hedge funds into exploiting it.⁵ Our contribution to the literature is (i) to simultaneously examine a number of the most prominent anomalies, and (ii) to consider how the profitability of each of these anomalies has been affected by liquidity-increasing events such as decimalization, as well as arbitrage proxies such as hedge fund assets under management, share turnover, and short interest.

The rest of the paper is organized as follows. Section 2 presents the list of anomalies we consider. Section 3 describes the data. Sections 4 considers portfolio and regression approaches, respectively. Section 5 considers possible rationales for attenuation, while Section 6 concludes.