Anomaly Discovery and Arbitrage Trading

We analyze a stylized model of anomaly discovery, which has implications for both asset prices and arbitrageurs’ trading. Our evidence based on 99 anomalies is consistent with new predictions that the discovery of an anomaly reduces the correlation between the returns its deciles 1 and 10, leading to diversification benefits for passive investors. These effects become correlated with the aggregate trading of hedge funds only after discovery. Hedge funds increase (reverse) their positions in exploiting anomalies when their aggregate wealth increases (decreases), further suggesting that these discovery effects operate through arbitrage trading.