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
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.