Chapter 4: Cross-Sectional Anomalies: Statistical Phenomena or Free-Lunch Opportunities

I extend the analysis of Kaplanski (2023) to explore arbitrage activity following the discovery of cross-sectional anomalies. After anomaly discovery, arbitrage capital reshapes out-of-sample returns, thereby creating a contrarian effect on top of the general decay in returns. As a result, the monthly first-day return is responsible for more than 10% of the portfolio value, which increases to 30% in case of monthly based anomalies. The continuous arbitrage activity suggests that arbitrageurs find anomalies profitable in the long run. This implies mispricing, which is difficult to reconcile with full rationality but can be explained via investors’ behavioral biases.