your broker beat a chimp when it comes to investment decisions?
Yes and no, say these Kellogg School scholars
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.
photos © Nathan Mandell
Prof. Kent Daniel
have to do with how one looks at the market, say Kellogg School
Professors Kent Daniel, Todd Pulvino
Vincent, who summarized their finance and accounting insights
during a recent "Nota Bene" seminar for second-year
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.
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.
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.
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."
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.
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.
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
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.
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
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.
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.