Learning Outcomes
After reading this article, you will be able to identify common market anomalies, explain how investor sentiment and liquidity constraints can lead to persistent mispricing, and evaluate the main limits to arbitrage strategies in practice. You will also be able to apply these concepts to CFA exam questions assessing the relationships between behavioral biases, liquidity, and the effectiveness of arbitrage in correcting deviations from market efficiency.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the real-world frictions and behavioral factors that can cause persistent mispricing in financial markets. Special focus is given to:
- Recognizing the role of investor sentiment in driving prices away from fundamental value
- Discussing the main limits to arbitrage and how these limits impede the correction of anomalies
- Analyzing the impact of liquidity constraints and investor flows on arbitrage effectiveness This topic is central for revising applications of behavioral finance and market efficiency in portfolio management and asset allocation.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which factors prevent arbitrageurs from immediately correcting market anomalies?
- How might investor sentiment contribute to sustained deviations from fundamental value?
- What is meant by 'limits to arbitrage', and how does illiquidity play a role?
- Give one example of a market anomaly that may persist because of arbitrage constraints.
Introduction
Conventional finance assumes that asset prices reflect all available information due to the actions of rational, profit-seeking arbitrageurs. However, real markets display persistent anomalies – predictable departures from what would be expected under market efficiency. Understanding the sources, persistence, and practical resolution of these anomalies is essential for CFA candidates. Two main reasons why anomalies endure are (1) the influence of aggregate investor sentiment, and (2) significant barriers that limit arbitrage, especially in illiquid assets or for strategies affected by investor flows.
Key Term: market anomaly
A pattern or regularity in asset prices that appears inconsistent with market efficiency and cannot be explained by standard risk-return models.
Investor Sentiment and Asset Pricing
Investor sentiment refers to the beliefs, moods, or heuristics of market participants that may be unrelated to fundamental information about securities. When sentiment dominates trading, prices can move away from fundamental value, and such mispricing can persist for meaningful periods.
Key Term: investor sentiment
The propensity of investors to trade or hold views that are not fully justified by rational, fundamental analysis.
When sentiment is optimistic, overpricing in affected assets (such as high narrative stocks) can result. Conversely, pessimistic sentiment can depress prices for unpopular or complex assets. In both cases, anomalies such as momentum, bubbles, or undervalued distressed stocks may arise.
Key Term: limits to arbitrage
Practical frictions and risks that prevent rational investors from fully exploiting and correcting mispricings in financial markets.
High investor sentiment often occurs in new, difficult-to-value, or attention-grabbing assets, exacerbating their price dislocations. Sentiment-driven flows can also cluster among retail investors, mutual funds, or index-tracking vehicles, further intensifying deviations from fair value.
Limits to Arbitrage
While mispricings can, in theory, be arbitraged away by smart traders, in practice, several frictions make arbitrage risky, costly, or even infeasible. These constraints allow anomalies to persist and make arbitrage a risky (not riskless) endeavor.
Major Limits to Arbitrage
- Fundamental risk: Arbitrageurs cannot perfectly hedge away the risk that news unrelated to mispricing may move prices in the short run.
- Implementation costs: High transaction costs, bid–ask spreads, and market impact especially for illiquid assets, erode the profitability of arbitrage strategies.
- Short-sale constraints: Restrictions, high costs, or the risk of recall make it challenging to profit from overvaluation.
- Noise trader risk: The risk that market sentiment may intensify before price correction, potentially resulting in losses for arbitrageurs forced to unwind positions prematurely.
- Redemption or liquidity risk: Professional arbitrageurs managing client capital may have to close unfavorable positions at a loss during market panics or periods of high redemptions.
Key Term: noise trader risk
The risk faced by arbitrageurs that irrational or sentiment-driven investors will move prices further away from fundamental value before correction occurs.
Liquidity and Arbitrage Effectiveness
Liquidity is a core component in the limits to arbitrage. Insufficient liquidity magnifies the costs and risks faced by arbitrageurs, impeding their ability to trade at prices close to fundamental value.
Key Term: liquidity risk
The risk of being unable to transact a security in sufficient size or at a reasonable price due to market depth constraints.
Less liquid stocks or asset classes (such as small cap equities, distressed debt, or emerging market securities) are more prone to persistent mispricings. Trading these assets incurs higher price impact, and wide bid–ask spreads mean arbitrageurs demand a larger price discrepancy to justify action.
During periods of market stress, liquidity can dry up abruptly, worsening arbitrage risks. Many prominent anomalies are strongest among less liquid securities and during high volatility markets, where arbitrageurs' ability to correct prices is most impaired.
Key Term: redemption (run) risk
The risk that investors in arbitrage funds withdraw capital during periods of underperformance, forcing managers to liquidate positions regardless of longer-term value.
Investor Flows and Arbitrage Constraints
Institutional capital flows and constraints faced by hedge funds, mutual funds, or other professional investors often exacerbate market anomalies. For example, when arbitrage strategies perform poorly in the short term, investors may redeem their capital, forcing managers to close positions at a loss. This redemption risk discourages taking large enough trades against mispricing.
Mutual funds or ETFs with strict liquidity mandates or daily redemption risk may not deploy significant capital to illiquid or slow-to-correct anomalies, allowing mispricings to continue. This institutional fragility is one reason why anomalies such as closed-end fund discounts or the value effect are more pronounced in segments where arbitrage is difficult or client flows are volatile.
Examples of Persistent Market Anomalies Due to Arbitrage Limits
Several well-documented market anomalies demonstrate how liquidity and sentiment can combine to stymie arbitrage:
- Momentum: Stocks with recent strong returns continue to outperform in the short term, even after adjusting for risk. Arbitraging momentum is risky and often exacerbated in less liquid stocks with high investor attention.
- Closed-end fund discount: Closed-end funds often trade at a discount to their NAV for extended periods, as shorting offsetting portfolios is impractical.
- Bubbles or fad stocks: Speculative surges driven by sentiment in new technology or "story" stocks can persist for years, as short-selling is difficult and price corrections may take longer than arbitrageurs' funding horizon.
Worked Example 1.1
A hedge fund observes a group of biotech stocks trading at high valuations, far above estimated net present value. While fundamentals suggest overpricing, short-selling these stocks is costly and exposed to the risk that positive sentiment or news flow may drive prices even higher. If the fund’s clients withdraw capital after several months of losses, the hedge fund could be forced to liquidate its position at even greater loss, leaving the anomaly uncorrected in the short term.
Answer:
In this scenario, short-sale constraints, noise trader risk, and the risk of client redemptions combine to impede arbitrage. The overvaluation can persist as the arbitrageur is unable, or unwilling, to take a sufficiently large position or may be forced to close it prematurely.
Revision Tip
Always link each anomaly to the frictions or behavioral factors that allow it to persist. For CFA exams, practice explaining not only the anomaly but also why arbitrage is hampered in specific contexts.
Summary
Persistent market anomalies reflect a combination of investor sentiment and significant limits to arbitrage. Barriers such as fundamental risk, costs, liquidity, and institutional constraints deter arbitrageurs from correcting mispricings, especially when investor flows are volatile or sentiment-driven. Liquidity shortages and redemption risk can magnify these effects and are often strongest in the very market segments where anomalies are most visible.
Key Point Checklist
This article has covered the following key knowledge points:
- Define key market anomalies and how they violate strict market efficiency.
- Explain the role of investor sentiment in intensifying or sustaining price mispricings.
- Identify and describe practical limits to arbitrage, including noise trader risk, short-sale constraints, and implementation costs.
- Evaluate how liquidity risk increases anomaly persistence.
- Assess how investor flows (liquidity, redemption risk) further restrict arbitrage in real markets.
Key Terms and Concepts
- market anomaly
- investor sentiment
- limits to arbitrage
- noise trader risk
- liquidity risk
- redemption (run) risk