Can Investors Profit using Academic Research?

The Efficient Market Hypothesis posits that the stock market is efficient at incorporating publicly available information. If that is true, then it should be next to impossible to select stocks that will produce returns superior to the overall market’s returns, after making allowance for the cost of risk. But decades of academic research have turned up numerous “anomalies.” These anomalies appear to show that there have been systematic ways to choose stocks that will “beat the market,” and that success is attributable not just to a few individuals with idiosyncratic skills.

In some instances, it has been possible to show that the trading costs of taking advantage of these anomalies would wipe out any superior returns that they might produce. But that does not explain the persistence of most of them. One of the first anomalies to be discovered, and perhaps the best known, is the historical tendency of the stocks of small-capitalization companies to produce superior returns to the overall market (though certainly not at all times).

As the label “anomaly” suggests, the hypothesis of market efficiency is intuitively reasonable as a representation of the normal state of affairs,  from which these phenomena are seen as departures. If many participants in the market know a strategy for beating the market, then they will use it until their trading drives up prices and the strategy ceases to provide value. The Efficient Markets Hypothesis posits that advantages are traded away almost instantaneously.

R. David McLean, of the University of Alberta, and his colleague Jeffrey Pontiff, of Boston College, have been conducting a large-scale study to see if the advantages of stock-market anomalies are traded away once they are published in academic papers and therefore become widely known, and if so, how quickly. McLean and Pontiff have not yet published their research, but McLean discussed it at a luncheon meeting of the Boston Security Analysts Society on April 15.

Three explanations for anomalies

McLean explained that there have been three responses to the documented existence of such anomalies.

One has been to say that they merely reflect “data mining” (also sometimes called “data snooping”). McLean referred to a 1998 paper by Eugene Fama, one of the fathers of the Efficient Markets Hypothesis, that made just this point. The argument is that if you test thousands of stock selection strategies, a few of them are bound to work through sheer luck. And if luck is the source of the winning strategies, hardly any of them can be expected to work during a time period outside the original test.

Another response, also identified with Fama, is that the success of the strategies is real, but the realized excess returns, called “alphas,” aren’t actually alphas. Rather, they are compensation for unrecognized systematic risks that are not included in risk models of the stock market but ought to be. This is the old problem of the “joint hypothesis” of market efficiency and any risk model: It is not possible to test the hypothesis of market efficiency independently of a model that provides estimates of the risks being incorporated into prices. (This response lies behind the Fama-French model that is an alternative to the Capital Asset Pricing Model.)

This is a conundrum. McLean said that he does not, however, have much sympathy for the argument, which is more a supposition that systematic risk should be able to explain away any regularity in the success of the stock-selection strategies. But he pointed out that one consequence of the argument is that, contrary to the first response, it implies that these strategies should be successful outside the time period of the original tests.

The third response is that these stock-selection strategies genuinely produce superior results. A likely consequence of this argument is that, because the strategies work, their effectiveness should decline, as they become widely known, to the point where they cease to work after taking into account trading costs.

The three responses to the evidence for successful stock-selection strategies imply three different possibly measureable results.