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In yesterday’s newsletter we noted the argument that “If a security did become overpriced because of the combined actions of irrational investors, smart investors would sell this security (or if they did not own it, ‘sell it short’) and simultaneously purchase other ‘similar securities’ to hedge their risks.”
Today I want to discuss some weaknesses in this argument. Shleifer, in Inefficient Markets, points out a number of reasons why arbitrage does not work well in the real world and therefore prices are not returned to fundamental value.
To be effective the arbitrageur needs to be able to purchase or sell a close-substitute security. Some securities, e.g. futures and options, usually have close substitutes, but in many instances there is no close substitute and so locking in a safe profit is not possible.
For example, imagine that you, as a rational investor, discover that Unilever’s shares are undervalued. What other security (securities) would you sell at the same time as you purchase Unilever’s shares to obtain a risk-free return when the price anomaly is detected?
If we were talking about the price of a tonne of wheat of the same quality selling on two different markets at different prices we could buy in the low-price market and simultaneously sell in the high-price market and make a profit (guaranteed without risk) even if the price difference was only 10p.
But what can you use in arbitrage trade that is the same as a Unilever share?
Well, you might consider that Procter & Gamble shares are close enough and so you sell these short. (We are assuming that selling shares that you do not own (and therefore have to borrow) is easy and available to a large number of potential investors. However, in reality, borrowing shares is costly, often impossible and open to only a few institutional investors. Also your period of going short is usually only for days, weeks or a few months rather than years.)
You expect that in six months the pricing anomaly will correct itself and you can close your position in Unilever by selling and close your position in P&G by buying its shares. But this strategy is far from the risk-free arbitrage of economists’ ideal.
Risks in arbitrage
You face the risk of other fundamental factors influencing the shares of Unilever and P&G (e.g. a strike, a product flop).
You also face the risk that the irrational investors push irrationality to new heights. That is, the price does not gradually move towards the fundamental value over the next six months, but away from it. If this happens you lose money as a buyer of Unilever shares and have no offsetting gain on P&G shares.
There is growing evidence of the problem of continue………………
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