PRACTITIONER’S BRIEF

FRICTION KEY TO EXPLOITING

STOCK MARKET INEFFICIENCIES
Rich Blake
Rich Blake is a veteran financial journalist who has written for numerous media outlets, including Reuters, ABC
News, and Institutional Investor.

Based on the paper “Global Market Inefficiencies” by Söhnke M. Bartram and Mark
Grinblatt (https://www.arx.cfa/post/Global-Market-Inefficiencies-4217.html).

WHAT’S THE INVESTMENT ISSUE?

The paper is one of a handful that seeks to address why some markets are less efficient than
others. Although it is conventional wisdom, this premise is not universally accepted.

Some academic research papers support the concept that developed markets are no more
efficient than emerging markets. Authors Bartram and Grinblatt dispute this. Others have
argued that investors rely too heavily on Fama’s Efficient Market Hypothesis (EMH)—that
is, that stocks always trade at their fair value—rendering any effort to profit from mispriced
stocks an exercise in futility.

On the one hand, the authors ask, if no one can ever profit from active management, then
what magical force exists to drive prices to fair value? They argue that a passive investor will
buy the index fund, whatever the prices of its component parts. Active managers, who have
performed relatively poorly of late, may well have another cycle to show off their talents—and
so will want to take note of where and when mispricings and market inefficiencies cross paths.

HOW DO THE AUTHORS TACKLE THIS ISSUE?

Bartram, of the University of Warwick, and Grinblatt, of UCLA, began their work by going
through a database of company financials that went back more than two decades to capture
all the information about the companies that would have been known at the time.

They constructed a robust set of synthetic portfolios—nearly 26,000 stocks from three
dozen countries—to theoretically trade on mispriced companies, with a few unique layers of

The views expressed herein reflect those of the author

and do not represent the official views of CFA Institute or the author’s employer.

© 2017 CFA Institute. All rights reserved. 1

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Practitioner’s Brief

variables to provide reality checks. Trading signals, suggesting a clearly identifiable deviation
of a stock’s price relative to its estimated fair value, were built using international point-in-time
accounting data covering 21 company-specific metrics. Trading activity was replicated with
transaction cost data from Elkins McSherry, the gold standard for tracking such expenses.
Transaction cost data included explicit commissions and fees as well as harder-to-quantify
market impact costs. These costs were converted to alpha reductions using portfolio-turnover
approximations, that is, two-way turnover.

WHAT ARE THE FINDINGS?

The results of running the mispricing replicating portfolios (and incorporating simulated buy/
sell executions) were definitive: Emerging and certain developed Asian markets were shown
to be relatively less efficient in countries with quantifiable market frictions—particularly
trading costs—that deter arbitrageurs. “If profits to trading strategies based on mispricing
estimates are a measure of market inefficiency, then profits should vary across countries as
a function of transaction costs, short sales restrictions, and other country characteristics
that might influence limits to arbitrage, thereby impeding the process that makes a country’s
stock prices reflect fair value.”

WHAT ARE THE IMPLICATIONS FOR INVESTORS

AND INVESTMENT PROFESSIONALS?
In regions where markets are most efficient, Bartram and Grinblatt caution that investors
need to be aware of the costs of active management, noting that it is unlikely the fees associ-
ated with active management will outweigh its value. A caveat here, though, is that the data
studied were annual accounting data. Conceivably, some improvement in the alpha may be
generated by the strategy, even in the most efficient global markets, when using quarterly data.

And there’s a catch as well: The least efficient markets, where the alpha opportunities may
be the largest, can easily be eroded by those frictions—in other words, super-sophisticated
investors are steering clear for good reason.

2 © 2017 CFA Institute. All rights reserved.

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