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Monkey business?

Can your broker beat a chimp when it comes to investment decisions? Yes and no, say these Kellogg School scholars

By Matt Golosinski

In theory, investment professionals ought to perform better than a monkey throwing darts at the Dow Jones listings.

In reality, the monkey does almost as well as seasoned arbitrageurs, finance experts who buy a security from one source and immediately sell it elsewhere at a profit.

  Prof. Kent Daniel
All photos © Nathan Mandell
Prof. Kent Daniel
  Prof. Todd Pulvino
Prof. Todd Pulvino
  Prof. Linda Vincent
Prof. Linda Vincent

The reasons have to do with how one looks at the market, say Kellogg School Professors Kent Daniel, Todd Pulvino and Linda Vincent, who summarized their finance and accounting insights during a recent "Nota Bene" seminar for second-year students.

In models that assume a "frictionless" environment, where transaction costs and information asymmetries are bracketed out of the equation, arbitrageurs can indeed generate "anomalies"—returns that are consistently greater than what predictive models expect, say the Kellogg experts.

However, real-world markets don't operate in this rarified air. And with respect to the anomalies that do occur, it's difficult for arbitrageurs to capitalize on them regularly.

As evidence, consider the popular and long-running (until 2002) Wall Street Journal feature that pitted analysts against a dart board and random chance. In this scenario, the pros came out on top 87 times out of a total of 143 contests. Using math that even a monkey could understand, this means that chance stock picks bested the professionals 56 times.

These results are unlikely to warm the hearts of those paying a premium for sage advice from analysts.

Advocates of the Efficient Markets Hypothesis (EMH), the standard economic paradigm for thinking about stock market returns, are not particularly surprised by the monkey's performance. Vincent explains that EMH holds that "an investor cannot earn abnormal returns by trading in securities markets because security prices reflect all available information" and because "competition among investors ensures assets are properly priced."

Vincent points out that actively managed mutual funds, on average, do not outperform the market index, especially after expenses. And for those that do, there is "little evidence of persistence" in their ability to outpace the index, she reports.

Pulvino and Daniel, both winners of the prestigious Smith Breeden Award for their finance research, have studied the limits to arbitrage, and shared some of their insights at Nota Bene.

Daniel illustrated some of the arguments driving arbitrage limitation by examining an example of an obvious mispricing from the Internet boom: a firm called PC Mall and its spinoff UBid, an online auction site that sold factory excess and refurbished goods.

UBid did well, but its parent company believed the spinoff's stock price still failed to represent the venture's true value, prompting PC Mall to "carve out" UBid, offering 20 percent of it for public sale.

The stock price skyrocketed, indeed providing opportunities for arbitrageurs. However, market frictions that included agency problems and long-term capital management issues (such as increasingly steep maintenance margin requirements), resulted in dramatic losses for UBid investors.

Says Daniel: "Assuming that agency problems make it difficult to raise additional capital [to cover margin], large bets on this mispricing are risky." Even though those relatively few investors who could stay in the game and cover their margins would eventually earn a return of about $10 per share, most investors lost money—some taking more thana 70 percent drubbing.

Pulvino's research indicates additional impediments facing arbitrageurs and investors. Imperfect information and market frictions can hinder arbitrage in two ways, he says.

An apparent mispricing creates uncertainty and requires the arbitrageur to investigate the reasons for the mispricing. Doing so results in potentially significant costs that may serve as disincentives. Furthermore, "imperfect information and market frictions often encourage specialization—which limits the degree of diversification in the arbitrageur's portfolio and causes him to bear idiosyncratic risks for which he must be rewarded," writes Pulvino in "Limited Arbitrage in Equity Markets" (co-authored with Mark Mitchell and Erik Stafford).

"These are some of the possible explanations why the monkey, a passive arbitrageur, can make such strong returns," says Pulvino.

Research such as this may also encourage some people to sink all their money in a low-cost index fund. Or find a broker with a tail and predilection for bananas.

©2002 Kellogg School of Management, Northwestern University