A very common question is, “how do you know when it stops working?” If there was a straightforward answer to this, it wouldn’t keep getting answered. It also doesn’t mean the subject is not worth pondering.

A recent paper, “What Drives Anomaly Decay?” by Jonathan Brogaard, Huong Nguyen, Talis J. Putnins, and Yuchen Zhang takes another stab at finding the answer. Before getting to their findings, I suggest that people read the recent blog post, “Alpha and Beta.” Beta is what we earn from passive exposure to a risk factor, literally a risk premium. Alpha is the money that we can make on top of the beta premium. The authors seem to conflate these, which I think is unhelpful. Risk premia exist because people want to avoid risk and will pay to have someone else bear the risk for them. Although the magnitude of these varies over time, I can’t see any reason these would ever go away completely. This would require a large change in how humans feel about risk. This seems unlikely. Add to this that we know of risk premia (credit, equity risk premium, and volatility risk premium) that have existed for as long as we have data, and the persistence seems to be a good bet.

But alpha sources are usually transient because they are inefficiencies which go away when people notice them, or at least when people start trading them (the most convincing argument for why markets are (close to) efficient is that traders push them back to fair value when they see things are mispriced).

With all that in mind, the authors find that the most important signal that an anomaly is going away is when the product becomes more liquid and more volume trades. This literally shows that the effect has been noticed and is able to be accessed by more traders. Note that this doesn’t imply that low volume automatically guarantees an edge. It just means that if there is an edge, volume tends to kill it. This finding is also in line with the fact that a lot of “inefficiencies” can be found by examining mid-prices and these go away when you more carefully consider whether you can actually trade at those prices. I won’t point fingers, but that is a common failing with academic papers.

The next alpha killer is the publication effect, where effects diminish after they are written about in academic papers. This effect is well known, although the authors say it is far less important than volume generally. This makes sense as volume increase is a more general effect. There is also the fact that many effects written about by academics were known to practitioners already, so publication might not give new information.

Finally, they say that passive investing into the broad market has increased market efficiency by reducing transaction costs and spreading liquidity across a wider range of assets. This seems unpersuasive. You could equally make the argument that passive investing increases inefficiency by reducing the scrutiny of stock specific details.

By far the best way of knowing when to give up on a strategy is to know why it exists in the first place. If that reason goes away, you can stop. But the other thing to remember is that strategies tend not to flip from positive edge to negative edge. The usual case is just that the edge drops to zero. From this perspective it is probably best to stick with things if they can cover costs. You won’t lose money and an idea that worked in the past is more likely to start working again than something with no history of success.

But this paper is still a good contribution to the problem.

Disclaimer

This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting, or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact HTAA or consult with the professional advisor of their choosing.

Except where otherwise indicated, the information contained in this article is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution of any future date. Recipients should not rely on this material in making any future investment decision.