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OPINION

Not learning

Not learning
September 22, 2016
Not learning

That's the theory. Recent research, however, shows that it isn't wholly true.

David McLean at the University of Alberta and Jeffrey Pontiff at Boston College recently asked what happened after academic research had uncovered 'anomalies' - equity trading strategies that appeared to be profitable. They found 97 such anomalies, including defensive and momentum effects, and mispricings based on measures of corporate governance, various valuation methods and corporate accounting measures such as the tendency for Joseph Piotroski's F-scores or high accruals (non-cash profits) to predict lower returns.

They found that after these anomalies were published in academic journals, their profitability fell by half. This might be because some of the alleged profits were illusory: Duke University's Campbell Harvey has claimed that a lot of alleged anomalies are "likely false". But it's also consistent with theory and common sense, that profits get bid away by competition.

Except for two things. One is that the profits weren't completely eliminated: they remained, on average, small but significant. The other is that this is only true in the US. Heiko Jacobs at the University of Mannheim and Sebastian Muller at the German Graduate School of Management in Heilbronn recently replicated McLean and Pontiff's research for stock markets outside the US. And they found that, in these, anomalies remained profitable even after academics had announced their discovery.

This suggests that investors don't learn. They don't quickly wise up to ways of making money. Why not?

One reason is that it is risky to do so. For example, defensive stocks expose their holders to benchmark risk - the danger of underperforming a rising market which might get a fund manager the sack; the same might be true for momentum stocks. This risk deters some investors from buying them, allowing others to reap good profits. This is consistent with efficient market theory, which says that above-average returns are possible as a reward for taking on extra risk.

 

 

A second reason lies in the short sales constraint. To fully exploit anomalies you need to short-sell overpriced stocks, such as ones with bad corporate governance or high accruals. Some institutional investors, however, cannot do this while many others find it difficult to do so because of shares' volatility or illiquidity. This is especially true for smaller stocks.

Although these factors might explain why anomalies remain profitable, it's difficult to see why they should apply more outside the US than in. Instead, there might be institutional explanations, hedge funds (who are often more willing to short-sell) are more active in the US than in some other markets. And there are perhaps closer links between academia and finance in the US than elsewhere, which might speed up the learning process.

Whatever the reason, there are two implications here. One is that economic theory alone isn't sufficient to explain the persistence of some market anomalies. We also need to know about market structure, such as constraints upon short selling. The other is that, in stock markets, simple theories are not wholly true - a fact that, of course, is not confined to equity markets.