The Limits to Arbitrage Revisited: The Accrual and Asset Growth Anomalies

Using idiosyncratic volatility as a proxy for arbitrage costs, the authors found that the highly publicized accrual and asset growth anomalies exist because of high barriers to arbitrage, occurring predominantly in the universe of stocks with higher arbitrage risks. Therefore, investors who seek to profit from the accrual and asset growth anomalies must bear greater uncertainty in outcomes than was previously understood. Recent research has examined the viability of such simple, fundamental anomalies as accruals and asset growth. For the asset growth effect, research findings generally suggest that periods of significant asset expansion or capital expenditures tend to be followed by periods of negative abnormal stock returns. A negative relationship between accruals and subsequent stock returns has also been found to exist, which suggests that company managers seek to manage earnings in the short term through discretionary accruals. A central question for informed practitioners concerns the extent to which various alpha signals can be effectively used to generate trading profits. In a perfect world, the arbitrage risk arising from the lack of close substitutes can be completely hedged away; thus, any investment signal with a link to excess returns can generate real trading profits. In reality, however, arbitrageurs are unable to fully hedge away all risks associated with a perfect arbitrage. In our study, we focused on the risks of arbitraging the well-known accrual and asset growth effects. We found that the mispricing associated with these two anomalies is largely driven by investor demands for greater compensation for bearing increased arbitrage risk. In particular, we examined whether the highly publicized accrual and asset growth anomalies exist because of mispricing associated with high barriers to arbitrage arising from a lack of close substitutes. Using idiosyncratic volatility as a proxy for these arbitrage costs, we found that both anomalies exist predominantly in the universe of stocks with high idiosyncratic volatility. Therefore, investors who seek to profit from the accrual and asset growth anomalies must bear greater uncertainty in outcomes than was previously understood. This uncertainty comes in the form of high idiosyncratic risk, which raises costs and hinders the profitable arbitrage of these two anomalous effects. We contribute to the literature by showing that the arbitrage risk arising from the lack of close substitutes can create significant limits to arbitrage for investors who seek to reap profits from asset mispricing. Investors may be unable to outperform the market on an after-cost basis even if seemingly significant mispricings are identified and persist over time. Most significantly, our findings highlight the importance of thoroughly investigating the arbitrage risk arising from the lack of close substitutes when exploring and implementing alpha signals. Our straightforward methodology could be a useful approach for practitioners who wish to verify the realistic opportunities to profit from an array of identified investment signals. Editor’s Note: Rodney N. Sullivan, CFA, is editor of the Financial Analysts Journal. He recused himself from the referee and acceptance processes and took no part in the scheduling and placement of this article. See the FAJ policies section of cfapubs.org for more information.