Nerds on Wall Street: Math, Machines, and Wired Markets

5.5. Finding Information and Inefficiencies to Produce Alpha

With the market neutral investment plan laid out, the quant investor is ready to start looking through financial databases, prices, ticks, SEC filings, and anything electronic to discover patterns or events that can be used to forecast returns.

How do we recognize market inefficiencies? There are, of course, many complicated answers, but first it's worthwhile to take a look at a golden oldie—an apparently simple market inefficiency: excess returns observed following stock splits. Don't run out just yet to make the down payment on that boat. This is not a perfect and inexhaustible source of four-cent nickels, and is not common enough to be used as the sole basis for an institutional investing strategy. Also note that the data for the nice-looking bar chart in Figure 5.7 ended in 1995, so further study is warranted.

A stock split is a perfect example of a fully public information event. In an efficient market, such a public event would convey no useful information. But for a long time in the U.S. stock market, a stock split did appear to convey information, and may still. The average listed stock over the past two decades has sold for about $50 in very round numbers. When the stock price gets too high, the company splits the stock two or three shares for one to keep the price affordable for employees and individuals without forcing them into odd lot purchases. Similarly, when a stock gets very low in price, companies do ...