Anomaly Discovery and Arbitrage Trading

Abstract

We analyze a stylized model of anomaly discovery, which has implications for both asset prices and
arbitrageurs’ trading. Our evidence based on 99 anomalies is consistent with the prediction that
the discovery of an anomaly reduces the correlation between the returns of its deciles 1 and 10
portfolios. This effect becomes linked to the aggregate trading of hedge funds only after discovery.
Hedge funds increase (reverse) their positions in exploiting anomalies when their aggregate wealth
increases (decreases), further suggesting that these discovery effects operate through arbitrage
trading.

Keywords: Anomaly, Arbitrage, Discovery, Arbitrageur-based asset pricing.

JEL Classification: G11, G23