The Growth and Limits of Arbitrage: Evidence from Short Interest
We develop a novel methodology to infer the amount of capital allocated to quantitative equity arbitrage strategies. Using this methodology, which exploits time-variation in the cross section of short interest, we document that the amount of capital devoted to value and momentum strategies has grown significantly since the late 1980s. We provide evidence that this increase in capital has resulted in lower strategy returns. However, consistent with theories of limited arbitrage, we show that strategy-level capital flows are influenced by past strategy returns, strategy return volatility, and that arbitrage capital is most limited during times when strategies perform best. This suggests that the growth of arbitrage capital may not completely eliminate returns to these strategies.
Risk and Uncertainty;