The first published paper that I know of to document that returns are predictable across stocks was published in 1972. In that paper, the authors showed that price level predicts returns in that low priced stocks tend to have higher returns than high priced stocks. Since then, this has been an active research area with numerous academic papers showing that various strategies based on observable firm traits (e.g., size, past performance) can predict returns across stocks.
In research conducted with Prof. Jeffrey Pontiff of Boston College, we asked how well these strategies perform after the strategy has been published in an academic journal. We replicated 82 different strategies that have been shown to predict stock returns in leading finance, accounting, and economics journals. We found that on average, the return of a strategy decays by 35% after a paper has been published. In other words, investors relying on a published strategy generating a 5% abnormal return should expect to make an average of 3.75% in abnormal returns during the years following publication.
Why does this decline happen? One explanation is that the abnormal returns of these strategies reflect returns to buying and selling mispriced stocks. When scholars discover a new trading strategy and publish a paper about it, investors begin to trade on that strategy, thereby pushing the prices of the stocks within the strategy towards “correct” or fundamental values.
Consistent with this idea, the post-publication decay is greatest in strategies that consist of larger stocks that are less costly to trade. These strategies decline by more than 35%, which seems reasonable because investors are more likely to follow a published strategy when the cost of trading in it is low. In contrast, when a strategy requires trading in smaller, more volatile, and less liquid stocks, investors are less inclined to try to exploit the strategy, and we find that such strategies decline less after the paper is published. Moreover, we find that after a strategy has been published, there is an increase in trading activity among the stocks in the strategy’s portfolio.
As for whether investors should follow strategies identified in academic papers, investors should on average expect to make 35% less on a strategy as compared to what is reported in a published paper. Investors should also keep in mind that these papers are written by researchers whose first priority is to better understand how financial markets work, and not to identify money making mechanisms. As a result, most studies do not estimate the costs of implementing the strategy, which can be substantial.
A silver lining in our results is the notion that academic research makes markets work better. What our findings suggest is that market mispricing is at least partially corrected once a study has drawn attention to it.
Prof. R. David McLean is visiting MIT Sloan from the University of Alberta. He recently coauthored the paper “Does Academic Research Destroy Stock Return Predictability” with Prof. Jeffrey Pontiff of Boston College.
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