Capital Market Efficiency and Arbitrage Efficacy

Abstract

Efficiency in the capital markets requires that capital flows are sufficient to arbitrage anomalies away. We examine the relationship between flows to a "quant" strategy that is based on capital market anomalies, and the subsequent performance of this strategy. When these flows are high, quant funds are able to implement arbitrage strategies more effectively, which, in turn, leads to lower profitability of market anomalies in the future, and vice versa. Thus, the degree of cross-sectional equity market efficiency varies across time with the availability of arbitrage capital.

Keywords: cross-section of stock returns; limits to arbitrage; market efficiency; anomalies; funding constraints; fund flows; mutual funds

JEL Classification: G14