Funding Constraints and Market Efficiency

We explore the premise that the degree of market efficiency changes dynamically as investment funds face time-varying funding constraints to arbitrage capital. We show that the returns to a composite long-short hedge strategy that encompasses relative value, momentum, short-run reversals, and accounting profitability, are higher when past returns to the strategy are low, and past volatility is high, which is when fund managers are particularly likely to be impeded in attracting funds. Furthermore, returns to the strategy also are higher when there are net outflows from funds that load heavily on the returns to the composite strategy. Our results support the notion that the efficiency of stock pricing is not a static concept but varies across time as agents face time varying constraints on arbitrage capital