Exploiting Inefficiencies: Limits to Arbitrage in Financial Markets

The efficient market hypothesis has become a cornerstone of modern financial theory, yet investment managers continue to outperform the market. This paradox reveals a contentious debate - just how efficient are financial markets? Can skilled investors hope to consistently beat the market? Or does the enigmatic EMH ultimately reign supreme?

The efficient market hypothesis, otherwise known as the EMH, is one of the most influential theories in modern finance. The EMH states that asset prices fully reflect all available and relevant information in financial markets. This simply means that prices should reflect data, news, releases, or even events that can impact the fundamental value of the asset. However, despite the popularity of the EMH, anomalies exist that suggest that markets are incapable of being completely efficient. This raises a key question - if prices sometimes deviate from fundamental value, why don't arbitrageurs immediately exploit these inefficiencies for profit?

In this post, we dive into the debate around market efficiency. We assess empirical evidence of market anomalies that appear to contradict EMH. However, we will also explore several real-world limits and market frictions that limit arbitrage activity and prevent the complete elimination of mispricing. Factors like short-selling restrictions, transaction costs, liquidity constraints, and model risk may hamper efforts to profit from market inefficiencies.

In the tug-of-war between informationally efficient markets and savvy investors seeking excess returns, where does the evidence point?

Forms of the Efficient Market Hypothesis

Under the Efficient Market Hypothesis(EMH), there are various forms of market efficiency:

• Weak Form - Asset prices reflect all information contained in historical prices. Only past price movements are fully incorporated into current prices. Technical analysis is fruitless.
• Semi-strong Form - Prices reflect all publicly available information. In this form, any meaningful fundamental information or events that affect expectations of future cash flows should be rapidly priced in. Difficult to beat the markets with only fundamental analysis.
• Strong form- Prices reflect all public and private information. Not even insiders can profit consistently. Under this form of EMH, consistently generating excess risk-adjusted returns through active management is nearly impossible, yet empirical evidence challenges this notion.

Evidence of Market Anomalies

While the EMH may seem like an extremely viable theory, there still have been dozens of market anomalies that seemingly contradict the EMH:

• Momentum - Stocks exhibiting strong past performance tend to continue outperforming in the upcoming terms
• Value effect - Low-valued stocks with low price-to-earnings or price-to-book ratios often offer higher average returns.
• Post-earnings announcement drift - Stock prices underreact to earnings surprises, allowing profits from investing in companies that beat or miss analyst estimates.
• Size effect- Small cap stocks have historically earned risk-adjusted returns higher than predicted by asset pricing models like the CAPM.

These patterns persist repeatedly on an empiric scale, even after adjusting for risk factors, which suggests that mispricing and market inefficiency rather than additional risk explain the abnormal returns.

Limits to Arbitrage

Given the evidence of apparent market anomalies, why don't traders identify and exploit these inefficiencies? The limits to arbitrage explain why mispricing can persist without being arbitraged away.

Key limits include:

• Short selling restrictions - Borrowing shares to short sell is limited for some stocks, making it riskier to bet against overpricing.
• Transaction costs - Trading fees reduce potential arbitrageur profits, especially for small deviations from value.
• Liquidity risk - Difficulty exiting positions in less liquid securities increases arbitrage risk.
• Model risk - Even when mispricing is identified, there is uncertainty in what the "true" fair value estimation is.
• Funding constraints - Arbitrageurs need sufficient capital to withstand mark-to-market losses from positions moving against them in the short run.
• Contractual restrictions - Investors like mutual funds face limits on leverage, derivatives, and short selling imposed by their mandates.

Market frictions significantly limit the scope for traders to force prices in line with fundamentals. Arbitrage can be expensive and risky to practice.

Conclusion

While the EMH remains a staple in financial theory, real-world markets likely sit between the extremes of perfect efficiency and gross inefficiency. Opportunities for achievable excess returns appear to exist, but extracting and profiting off them consistently is a different challenge. Limits to arbitrage allow pricing anomalies to persist, at least to a certain degree, without being fully eliminated. The debate around market efficiency and active management continues to stir passionate opinions on both sides. However, the truth likely lies in shades of gray rather than completely black and white.