On the Limits of Arbitrage

On episode 28 of The Wealth Cast, Eduardo Repetto of Avantis Investors joins Chas to discuss the Limits of Arbitrage, a concept which explains strange price action in the markets. With “meme stocks” such as GameStop and AMC showing unusual behavior over the past several months, Eduardo discusses how the Limits of Arbitrage impact the market’s ability to correct pricing anomalies.

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The summary below has been created by a professional transcription vendor upon review of the recorded presentation. Please excuse any typos as well as portions noted to be inaudible.

Hello, and welcome to The Wealth Cast. I’m your host, Charles Boinske. On this podcast, we bring you the information that you need to know in order to be a good steward of your wealth, reach your goals, and improve society.

Today I’m joined by Eduardo Repetto. Eduardo is the Chief Investment Officer of Avantis Investors. Prior to joining Avantis, Eduardo was the co-CEO and Director at Dimensional Fund Advisors, where he worked from 2000 to 2017. Today, Eduardo and I are going to talk about a number of topics central to the idea of the Limits of Arbitrage. And this is a concept that says there are limitations to how prices adjust in the capital markets to reflect what we both believe to be the relative efficiency of markets.

So it’s a—this is an important concept that can explain some of the pricing anomalies that appear periodically in the marketplace that you may have seen, or may exist in companies like GameStop, or AMC. I’m very glad to have Eduardo’s perspective on this important topic. Hope you enjoy the show.

Eduardo, welcome to The Wealth Cast. I’m so glad to have you here.

Chas, it’s always a pleasure. Some other day, we’ll do fly fishing, but today we are going to speak about finance.

Okay, so that sounds perfect to me. I’ll take you up on the fly fishing part. One of the things I thought would be interesting to talk about, that I would like to get your opinion on, or your perspective, is something that we’ve seen in the marketplace over the last year or so, that seems to fly in the face of our belief that “markets work.” And that is, we’ve seen stocks like GameStop and AMC rise in price so much that it seems to be detached from the fundamentals. And it seems to take a long time for that pricing to be adjusted for in the marketplace. And it sort of calls into question at some level, the idea that, as I mentioned, that markets work. And I wondered if I could get your perspective on strange occurrences like that in the marketplace.

That’s a very interesting topic. And you know, all of us have been looking at GameStop, and I remember when all that was going on, and it was an amazing roller coaster. You know, from the point of view of science, there will be papers written about this, and it will be very, very interesting. But this doesn’t trouble me in saying I still believe in market efficiency. But there are limits on how you define efficiency, because there are costs. And let me speak about this. So let’s suppose that you can say, and this is if you can say that the stock goes beyond fundamentals, and the price basically becomes a little bit irrational, let’s call it, later. And I’m putting a caveat, there’s—let’s assume that we can do that. And then roll on into the depths. Let’s assume that we can do that, and the price and price goes up and up and up beyond fundamentals.

So what should happen if we are thinking about markets and rational investors? Well, the first thing that you were saying: the price is going up a lot. Now, the rational investor, or buyer will sell—the first thing that you will see. And then you will see people shorting it. And so trying to get the price to the place that people think is the price related to the fundamentals.

Now, think about the people shorting. The people shorting have costs. And so if the amount of money that they will make shorting is more than their cost, they will step in. If not, they will not step in, because that’s part of market efficiency. That’s why I’m saying, the pie is bigger than the little piece of the pie that sometimes we see. And it’s not only cost, it’s risks. Because if they’re running too much risk, and the price keeps on going up—at some point, you know, for the money that they think that they’re going to be making, the risk is too high. So the profits are not worth the risk at some point. And that is still rational. And that—if you think of market efficiency in a broader sense, that makes sense, because we always pick up people coming in and trying to act on prices after considering their own costs.

So if you think about all that, … this event, market efficiency and the process, and costs, still holds. If you put a little bit of context that’s known, there is a part of literature in academics, financial science academics, called “Limits of Arbitrage.” And what does it mean, Limits of Arbitrage? Limits of Arbitrage means, when things go where prices become too high, let’s suppose, people will come in and short. But there are limits, because it’s those people coming in and trying to short the stock, are running too much risk, or too much cost, they will not step in, because there is no profit for them to step in. So you will imagine that people will sell a stock, when the price went up a lot. So people will sell a stock. But the next step—if buyers keep on buying—is shorting. But those people trying to short are facing these Limits of Arbitrage and there is stepping back.

There are great papers about that, Chas. A very famous case of this is when we were younger, Chas, is Palm and 3Com. And your audience really may want to look at that paper, because it’s a typical case of Limits of Arbitrage—the costs and risks of shorting are so high, that there is not enough shorting to push the price to a place that makes sense. So that’s on one side. If we think on the other side it says, “Okay, but who is buying?” You know, because, you know, there is a lot of capital here, you know. I think GME was around a billion dollar company, and became then a 20-something billion company. So who is buying?

And we’re facing something very interesting, if you go back to the French Revolution, and I know that you like history. You go back to the French Revolution, one of the neighbors of the French Revolution was print, you know, people started making posters. So the dissemination of information through print was much faster than word of mouth and people just lecturing others. And now we have this internet that creates chat groups, Reddit groups that I’m not part of—my kids are—and you have the GME Reddit group, you know, how many people were in that GME Reddit group? At the time it was 6 million people. Now it’s 10 million. So you know, and now, so if you have 6 million people, and each one put a thousand dollars, to buy it, because for whatever behavioral trending, love—I don’t know for whatever reason, I am not in their minds, they say, “I don’t care about fundamentals, we are going to this because conviction,” I don’t know how you call it. And each one to put in a thousand bucks. Six billion dollars. That’s not real,

That’s real money!

That’s a lot of buying power. And if you are going to try to collect your pennies to correct the price, in front of that machine coming towards you, that’s a risky proposition. So that’s where the Limits of Arbitrage starts coming in. And I’m only telling you a thousand dollars, I’m not telling you to put in three, ten thousand dollars. So that’s interesting.

Yeah, it is interesting. And I think just for the audience’s benefit, when we talk about shorting stocks, which maybe everyone’s not familiar with, that’s the process of basically borrowing a stock that you don’t own and selling it. And when you do that, you have to go on margin or, you know, there’s a cost to doing it. And then at some point in the future, you have to buy that stock back, to close out the position, and the difference in price there is your profit, less your cost of borrowing.

And my understanding is, and you can correct me if I’m wrong—that in these types of situation, the cost of borrowing that stock, or the availability of that stock, becomes such a dear commodity, that the costs go through the roof, and that inhibits your ability to short the stock, to bring it back to its natural equilibrium in price. Is that a fair—

—You are absolutely right, and sorry for using the word “short” without explaining it. With shorting, you think about hedge funds, you always think about shorting. And so what they do? They think that the price of a stock is too high, so they sell it without having it in the hope that the price will go down, and then they can buy at a lower price that they sold it and make the difference.

What’s that risk? The risk is two prong: One is the costs. By just saying, because when they think everyone wants to short something, the cost of borrowing to sell it before having it is too high. And the other one is the cost is that you’re betting that the price will go down. But if the price goes up, instead of going down, you’re selling something then, and the price becomes 20, 30, 50, 100, 500, you are losing money, because you will have to buy at a price that is much, much higher than the one that you sold at. So shorting is a very risky proposition. But people do it, because they think they’re making money.

And your downside in shorting is unlimited, relative to your downside, when you buy the opposite, when you buy a stock, which is called buying it long, right? Because the stock could go to infinity in price, and you have to buy it back at infinity, which I’m not sure anybody has that much money, right?

And Chas is nailing it, because what happens is we are borrowing a stock, and you’re selling it to someone else. And you know, if the price goes up and up and up, the person that lent you the stock, at some point, starts getting nervous, because you have to give the stock back to them. But if the price that used to be 10, now is 100, we have to have the capital to buy it at 100 and return the stock to them.

So what you have is the famous margin calls. So what it means is saying, “Hey, I don’t trust that you’re going to return that stock to me, I’m not going to let you borrow that stock for any longer. Give me my stock back right now.” So that is that these people have to go to the market and buy it, no matter what the price, in order to return it. And that pushes prices up and up and up against them. So it’s like a vicious cycle there at that point.

And that’s basically what we saw with GameStop when it went to 500 bucks. And to be fair, this is not the first time. If you go back in time, there is a very famous case with Volkswagen and Porsche. Porsche tried to take over Volkswagen, and it didn’t go very well. And the price of Volkswagen spiked dramatically, because people needed to close this short position because of calls, margin calls.

And we have seen these things before in the market. So when we are looking in the screen at GME and say, “My goodness, there are margin calls here.” And so there are things that you know, that tells you that efficient market is a failure? No, by no means. They are telling you that the costs of making those prices a little bit more rational are so high, and the rates are so high, that those prices will take an excursion, a diversion from reality. Because of behavior, you know, “love affair,” let’s call it, I don’t know. Everyone has them, thinks crazy for love. So these love affairs with the stock, that is way beyond rational price in fundamentals, and that’s where behavioral finance and rational markets stepping in.

Yes, understood. So that, you know, in review, the idea that in a perfect world, all investments of—identical assets, all identical assets have identical prices. And that doesn’t mean necessarily they’re the identical company, it just means the cash flows and risk associated with one investment, right, are the same as the cash flows and risks associated with another investment, and therefore those prices should be basically the same. And this idea holds true even under the conditions of a GameStop or an AMC. It’s the cost of actually executing the arbitrage that interferes with that rational equilibrium.

Yeah, this is a very fair point. And but Chas, let’s suppose that we are managing money, and we have GameStop. So you have this precious fruit that everyone wants to buy today, to take to the party tomorrow, yeah? Well, if you have the stock, you have the possibility—you can keep it. But then the price pressure that we’re saying that will push the price up a lot may disappear, and you can sell it at the right time. Or you can say, “Hmm, everyone wants what I have. Maybe it’s time to let go, and let someone else have it. Or maybe we’ll buy it later, or we never buy it.” 

So, and that’s the difference between people shorting, and if people already own The people shorting doesn’t have that stock, so they have to borrow and everything. If you own it, you can deliver, and you get rid of what everyone wants today. You know, I remember, my kids just during Christmas, or at least when my kids were younger, there is a toy that everyone wants. And then you go to, when I was younger, my kids were younger, so I went to Toys R Us and tried to buy it, but then it’s gone and then you had to buy in the secondary market at ten times the price, and the same with concert tickets and whatnot.

So the story is the same. Suddenly there is a love affair for something beyond fundamentals—if you had the stocks, it’s a great opportunity to realize some value for your clients.

So just the discipline and rebalancing and portfolio management can make a huge impact—a positive impact—under those situations. 

Absolutely.

Yeah, I think it’s natural. You can understand the emotional aspects of investing. You see it all the time. At some point, those emotions drag you from being an investor to being a speculator, right? That’s the thing that pulls you across the border between the two. And the problem is, in my view, no one waves a flag when you cross the line between investing and speculating. It happens sort of, without—for most people—without knowing it. And that can be very dangerous. And I suspect that when the studies are done of the phenomena of GameStop and AMC, etc., there’s going to be some evidence that this definitely occurred, and that the profits made, or losses incurred by people were much larger in case of losses than we would even imagine they might have been.

There was a humongous wealth transfer from one set of investors to another set of investors, and someone made, probably some money. And a lot of people, a lot—a lot of money. And there will be studies, I can say. But a lot of what you say is speculation and investing. Because if we go to the, you know, the very grandfather’s of finance, Graham and Dodd, they say, “Investing is analyzing the profits, and the risks in some way associated with those profits.” But here, it’s just, the love affair is just to chase one particular stock. It’s just crazy, in some sense.

In any way, Eduardo, in your view, do these kinds of experiences change at all the way we should think about investing in the future? My thought is, someone out there is going to think, “Well, if I could just find the next, you know, GameStop and get into it before people drive it to $500 a share,” or whatever the price was, the lure of that is really attractive. And it will pull people from being investors into speculators, and they may not even know it. But in the aggregate, I don’t imagine this changes the basics of finance, or the basics of how we should invest, at all.

Chas, it will not change how you invest—I always say you want to fix your pipes, you hire a professional to fix your pipes. You want to fix your health, you go to a doctor. If you don’t know finance, and you need to invest, go to a specialist. That’s why you have an advisor. If you don’t know, and you’re trying to learn your own, it may be a little bit risky for you. Because you know, it’s very difficult to save money and put it into risk without knowing—maybe not the best idea. That’s why there are professionals there to help.

You know this, “I want to discover the next Gamestop.” You know, it’s kind of crazy, because you’re saying, “I’m wanting to get before everyone, and just leave before the first guy starts leaving.” This is a musical chairs game. How you know that someone is not going to do it before you? Are you going to bet on your savings for a lifetime to do that musical chair? You know, people have a lot of technology, knowledge—and why do you think you’re better than that?

So there was a young person—and this is not a matter of age, you know, by any means, it’s just—but this particular person was speaking with me and saying, “You guys don’t know this. We are very different. We invest with sentiment.” And I said, “Well, you can invest with sentiment. I love every stock that I have, every ETF that we manage, I love all of them. But at the end of the day, fundamentals matter. A price cannot go to infinity, fundamentals are not there.” You know, things have to rationalize. You’re not going to go and buy an apple for a million dollars, because you can buy somewhere else, maybe a pear or something else, for a much reasonable price.

And so that’s the discipline that someone that knows finance, like financial advisors bring to the table and help advise investors basically improve the outcomes. And that’s very, very important.

Yeah, it’s so important, as I’ve seen over the years, and I think you would agree, that the discipline of the investment process, you know, for clients, whether they be institutions or individuals, is really the engine of their overall objective or their plan, so to speak. And it needs to be very concerned about taking outsize risks with little payoff. And this risk in chasing things like GameStop, or whatever the stock du jour is, is a risk that you probably shouldn’t rationally expect to be compensated for, for taking.

No, this is like basically walking on the street—if you hold GameStop in your portfolio, this is like walking on the street and seeing a hundred dollars there. You should grab it.

Right.

Because it’s random good luck, don’t expect to have it again. But if it happens, in the case of GameStop, you have it in your portfolio, the price goes very slowly up, sell it. And you know, you have this—indexing is a little bit interesting here, because indexing is like, I have GameStop, the price goes to infinity, I’m not going to sell it, I’m going to keep it. It’s like saying, “Hey, I walk into the street, and there’s a hundred dollars, it should not be there, so I’m not going to pick it up.” 

So you can be a little bit more clever than the indexing.

Right, right.

But also at the same time, you should have the discipline and the realisation that “Look. Don’t go on trying to find a hundred dollars in the street, because you can walk three years and find absolutely nothing, waste a lot of money, a lot of time. Just be disciplined investors, look for low fees, low turnover, very tax efficient vehicles, and have a decent asset allocation that fits your needs.” And that’s why advisors step in there and say, “What are your needs? What are your preferences, your cash flows,” and step in and create a good asset allocation.

Yeah, it’s all about balancing risk. And I think over the long term, the more clear we can make it for investors that these phenomena like a GameStop are just that—you can’t predict them ahead of time, they’re going to happen, there’s going to be something else down the road—but don’t let that dissuade you from your long-term strategy, assuming that strategy is well considered and appropriate for you, etc, it’s not something that should disturb or revolutionize how we think the markets work.

No, no. And it’s not the first time that this happened. As I said, look, there are papers from the past. I highly recommend anyone that wants to read those papers, go and read them. With Palm and 3Com, there are papers on that, and it’s called Limits of Arbitrage in Volkswagen and Porsche, you know, Chas. And advisors know these things, we know these things. And if happens, we are walking on the streets and there is a hundred dollars, we’ll pick it up for the portfolios.

Yeah.

But we’re not expecting them to happen.

No, it’s basically random chance. So what we’ll do, in the notes of the podcast, we’ll put the articles that you referenced during our conversation. I’ll also put a link to your company so folks can follow up with, and read more about, what you’re doing. And I hope we have a chance, Eduardo in the not-too-distant future to have another conversation about something interesting in finance. I really appreciate you taking the time.

It’s always a pleasure. You know, these kind of conversations always teach me something. So I always appreciate having these conversations.

Well, thank you so much. Have a great day.

Thank you, Chas.

Thanks for joining me and Eduardo today to talk about market efficiency and the Limits of Arbitrage. In the show notes for today’s episode, we’ll include some links to some further readings on Limits of Arbitrage and market efficiency. Please feel free to visit that site and take advantage of those resources. And I’ll look forward to the next time. Thanks again for joining us. Have a great day.

About Eduardo

As Chief Investment Officer of Avantis Investors, Eduardo is responsible for directing the research, design and implementation of its investment strategies, providing oversight of the investment team and the firm’s marketing initiatives, and interacting with clients.

Prior to Avantis Investors’ establishment in 2019, Eduardo was Co-Chief Executive Officer, Co-Chief Investment Officer and Director at Dimensional Fund Advisors LP (“DFA”) until 2017. While at DFA, Eduardo provided oversight across the investment, client service, marketing, and operational functions of DFA and oversaw their day to day operations, directed the engineering and execution of investment portfolios and was involved in the design, development and delivery of research that informed the firm’s investment approach as well as its application through portfolio management and trading.

Dr. Repetto earned a Ph.D. degree in Aeronautics from the California Institute of Technology, an MSc degree in Engineering from Brown University, and a Diploma de Honor in Civil Engineering from the Universidad de Buenos Aires. Eduardo is a Trustee of the California Institute of Technology. He is the recipient of the William F. Ballhaus Prize from the California Institute of Technology for outstanding Doctoral Dissertation in Aeronautics and the Ernest E. Sechler Memorial Award for his teaching and research efforts.