noisy and the payoff horizon is short (such as the small firm effect in Janu-
ary). A “noisy” anomaly like the value-glamour anomaly is accepted only
slowly, even by relatively sophisticated investors.
5.ConclusionOur chapter describes the workings of markets in which specialized arbi-
trageurs invest the capital of outside investors, and where investors use ar-
bitrageurs’ performance to ascertain their ability to invest profitably. We
show that such specialized performance-based arbitrage may not be fully
effective in bringing security prices to fundamental values, especially in ex-
treme circumstances. More generally, specialized, professional arbitrageurs
may avoid extremely volatile “arbitrage” positions. Although such positions
offer attractive average returns, the volatility also exposes arbitrageurs to
risk of losses and the need to liquidate the portfolio under pressure from
the investors in the fund. The avoidance of volatility by arbitrageurs also
suggests a different approach to understanding persistent excess returns in
security prices. Specifically, we expect anomalies to reflect not some expo-
sure of securities to difficult-to-measure macroeconomic risks, but rather,
high idiosyncratic return volatility of arbitrage trades needed to eliminate
the anomalies. In sum, this more realistic view of arbitrage can shed light
on a variety of observations in securities markets that are difficult to under-
stand in more conventional models.
THE LIMITS OF ARBITRAGE 99