Will J. Armstrong

Smart Money, Dumb Money, and Capital Market Anomalies

We investigate the dual notions that “dumb money” exacerbates well-known stock return anomalies and “smart money” attenuates these anomalies. We find that aggregate flows to mutual funds (dumb money) appear to exacerbate cross-sectional mispricing, particularly for growth, accrual, and momentum anomalies. In contrast, hedge fund flows (smart money) appear to attenuate aggregate mispricing. Our results suggest that aggregate flows to mutual funds can have real adverse allocation effects in the stock market and that aggregate flows to hedge funds contribute to the correction of cross-sectional mispricing.

Capital Market Efficiency and Arbitrage Efficacy

Market efficiency requires that arbitrageurs are able to raise the capital needed to arbitrage away mispricing in the cross-section of stock returns. We identify a set of capital constraints that impede the flow of funds to arbitrage strategies. When this flow is particularly curtailed, investors are unable to fully implement arbitrage strategies, allowing some level of inefficiency to persist. In turn, this leads to higher cross-sectional return predictability and stronger performance of arbitrage strategies in the future, as mispricing is eventually corrected. Thus, the degree of market efficiency is not a static concept but varies across time as arbitrage agents face time-varying constraints to arbitrage capital.Efficiency in the capital markets requires that capital flows are sufficient to arbitrage anomalies away. We examine the relation between flows to a quantitative (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.

Two Centuries of Innovations and Stock Market Bubbles

The interplay between innovation and the stock market has been extensively studied by scholars across all business disciplines. However, one phenomenon remains understudied: the association between innovation and stock market bubbles. Bubbles— defined as rapid increases and subsequent declines in stock prices—have been primarily examined by economists who generally do not focus on individual characteristics of innovations or on the consequences of bubbles for their parent firms. We set out to fill this gap in our paper. Using a sample of 51 major innovations introduced between 1825 and 2000, we test for bubbles in the stock prices of parent firms subsequent to the commercialization of these innovations. We identify bubbles in 73% of the cases. The magnitude of these bubbles increases with the radicalness of innovations, with their potential to generate indirect network effects, and with their public visibility at the time of commercialization. Moreover, we find that parent firms typically raise new equity capital during bubble periods and that the amount of equity raised is proportional to the magnitude of the bubble. Finally, we show that the buy-and-hold abnormal returns of parent firms are significantly positive between the beginning and the end of the bubble, suggesting that these innovations add value to their firm and to the economy, in spite of the bubble. Our findings have important implications for managers interested in commercializing innovations and for policy makers concerned with the stability of the financial system.

Funding Constraints and Market Efficiency

We explore the premise that the degree of market efficiency changes dynamically as investment funds face time-varying funding constraints to arbitrage capital. We show that the returns to a composite long-short hedge strategy that encompasses relative value, momentum, short-run reversals, and accounting profitability, are higher when past returns to the strategy are low, and past volatility is high, which is when fund managers are particularly likely to be impeded in attracting funds. Furthermore, returns to the strategy also are higher when there are net outflows from funds that load heavily on the returns to the composite strategy. Our results support the notion that the efficiency of stock pricing is not a static concept but varies across time as agents face time varying constraints on arbitrage capital.