Anomaly Discovery and Arbitrage Trading

We analyze a model of anomaly discovery and test its new predictions on both asset prices and arbitrageurs' trading. Consistent with existing evidence, the discovery of an anomaly reduces its magnitude and increases its correlation with other anomalies. Using 99 anomalies, we test the new predictions of the model: We find that the discovery of an anomaly reduces the correlation between the returns of its long and short legs, leading to the externality of diversification benefits for passive investors, and that these effects are stronger when arbitrageurs' wealth volatility is higher. In the model, these effects are generated by the post-discovery long-short arbitrage trading. Consistent with this prediction, we find that hedge funds exploit an anomaly more intensely after its discovery by trading in opposite directions in its long and short legs. They increase such trades when the aggregate hedge fund asset under management (AUM) increases and unwind them when the AUM decreases. All these effects are stronger for anomalies discovered by studies with more citations