Aurora Borealis
1 February 2010 CFA Institute Journal Review

Presidential Address: Sophisticated Investors and Market Efficiency (Digest Summary)

  1. Michael Kobal

It is often assumed that sophisticated investors make markets more efficient. The author explores how strategy crowding and the effects of leverage decisions can create new externalities among sophisticated investors, potentially rendering markets less efficient. He suggests that a fresh look at the capital requirements on and regulation of sophisticated investors is needed, with the goal of mitigating these externalities and potential fire-sale effects.

The author explores implications for efficiency in markets that are increasingly dominated by institutional or sophisticated investors. It is commonly assumed that as sophisticated investors’ trading activity grows, prices more readily converge to an efficient equilibrium. The author explores the possibility that institutional investors create externalities that potentially increase market inefficiencies. He considers the effects of crowding in certain strategies and investors’ privately optimized leverage ratios. Recent real-world examples of the results from these factors include a “quant crisis” in August 2007 and the demise of Long-Term Capital Management in 1998.

The author’s approach differs from that of others in that he assumes that arbitrageurs have rational expectations, make optimized leverage decisions when entering positions, and have access to a potentially infinite amount of equity capital. He constructs a relatively simple model to explore the effects of crowding and leverage. To explore crowding, the model assumes that although an ample amount of capital is available to profit from any stock opportunity at any time, no individual arbitrageur knows exactly how much is available to market participants in aggregate. The model also assumes that the profit opportunity has no fundamental anchor—that is, the arbitrageurs aim to profit from some price inefficiency without reference to any estimate of fundamental value. Examples of strategies without a fundamental anchor include buying a basket of small-cap stocks in December to profit from a “Santa Claus rally” and buying stocks that are expected to be added to a widely followed index.

Studies that address arbitrage capital typically assume that it is small relative to available trading opportunities such that arbitrageurs must lever up. The author focuses on capital structure from a long-term perspective and asks whether inflows of new capital tend to drive down arbitrageur leverage. The model assumes that each arbitrageur either can raise permanent equity capital at a per-unit cost or can borrow on a short-term basis at zero percent interest and that the potential leverage ratio is capped. Various capital structure strategies are then tested in various scenarios to determine likely leverage strategies under conditions of rising capital inflows from sophisticated investors.

The author finds that as arbitrageur capacity grows, expected returns on a specific strategy are driven to zero. But when uncertainty exists about the aggregate degree of crowding and the strategy is untethered to a view of fundamental value, prices no longer necessarily converge to fundamental value. In fact, prices can diverge more from fundamental value in that situation than if arbitrageur activity were not present at all.

An example of this divergence occurred when Morgan Stanley Capital International (MSCI) changed its method of constructing its MSCI indices from a market-capitalization weighting to a free-float weighting. Arbitrageurs traded on the pending reweighting in advance of the first implementation date of 30 November 2001. Theory would suggest that the arbitrageur activity would drive prices to equilibrium ahead of implementation such that prices would change little on 30 November. At least one study showed, however, that an arbitrageur position on the day of rebalancing would have lost an aggregate of more than 6 percent, which suggests that arbitrageurs may have crowded into a strategy untethered to fundamental value and thus added inefficiency to market prices.

The effects of crowding and leverage in a market increasingly filled with sophisticated investors call into question the presumption that, absent policy intervention, the market should necessarily grow more efficient, even over the long term. The author suggests that capital requirements are better designed with the purpose of mitigating potential fire-sale contagions among institutions than for their more traditional role of simply protecting senior claimants. At the same time, overly stringent leverage restrictions can unduly hinder arbitrageur activity and contribute to inefficiency. Thus, a better approach might be to limit restrictions on leverage and supplement them with ex post market intervention. For example, if fire-sale conditions begin to manifest, the government could act as a market maker of last resort (e.g., the Troubled Asset Relief Program) or provide financing on favorable terms.

Finally, as the perceived cost of equity capital is reduced, arbitrageurs finance themselves more conservatively, which limits the need for regulation. Thus, policymakers might explore ways to reduce the perceived costs of equity capital rather than increase leverage restrictions.

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