Thursday, July 18, 2019

Arbitrage Is Alive (at the sports book)

We've mentioned how rare it is to find honest-to-goodness arbitrage in the real world.
Not talking pair trades or hedges or all the other things that kinda sorta look like an arb, and definitely not talking M&A's so-called "risk arbitrage" where the emphasis had better be on first syllable.
No, just the old-fashioned definition: The simultaneous purchase and sale of the same asset in different markets.* Simple. More after the jump.
As the bettor points out:
I just made $500 by walking next door. ($2k was Max unfortunately)
Regarding  the trans-atlantic gold-point arbitrage mentioned below, old J.P. Morgan often had to settle for a mere $1000 profit per $1,000,000 invested after insurance and shipping costs to move the gold from/to London/New York but he took it every time it arose because it was a real arb.

*In 2013's "My Second-to-Last Comment on Izabella Kaminska at Tyler Cowen's Marginal Revolution" economist Cowen had linked to one of Izzy's pieces where she riffed off of Fukuyama with the phrase "The end of arbitrage" which unfortunately exposed the ignorance of a couple of Tyler's commenters but gave me a dandy jumping off point:
"In the comment section Marginal Revolution's usually perceptive, articulate and good looking commenters don't acquit themselves well on this post."
That was before the following two comments:
Becky Hargrove May 3, 2013 at 12:18 pm
There is plenty to quibble with in Kaminska’s assertions but I’ll just make a note about point seven. One assumes she sees greater efficiency and abundance as a positive gain for people in general. But…the end of arbitrage? That is also the end of greater attributable valuation for human skill, someone please send her a memo.
steve May 3, 2013 at 12:28 pm
I was taking the article half seriously when I read the “end of arbitrage”. All I can say is this marks it as quackery. Oh sure, arbitrage may end up being primarily the domain of computers working at lightning speeds. But, the end? Hogwash, there will never be perfect markets.
People, people, people arbitrage opportunities have been disappearing for the past 150 years!

I guessing the two commenters didn't have the definition: "The simultaneous purchase and sale of the same instrument in different markets at different prices" pounded into their head so often their ears bled.
I did.
How many arbitrages do they think present themselves each year?

Spotting and acting on an arb is pure alpha and here is a dirty little secret:
The entire amount of alpha available to the entire hedge fund industry is only $30 billion per year.
As reported by a hedge fund maven via Investment News back in 2006:
...PHILADELPHIA - Everyone in the crowd assembled for the CFA Institute's hedge fund conference took notice when David S. Hsieh said that the amount of alpha available in the hedge fund industry each year is $30 billion.

Mr. Hsieh, a professor of finance at the Fuqua School of Business at Duke University in Durham, N.C., presented a synopsis of his ongoing research, which focuses on the style, risk and performance evaluation of hedge funds, at the Feb. 16 conference here. As part of his work, Mr. Hsieh questioned whether flows into hedge funds are causing a decline in hedge fund returns and what might happen if the high rate of inflow continues.

Because of difficulties in obtaining reliable hedge fund data, Mr. Hsieh used fund-of-hedge-funds data and broke down returns into alpha and beta sources. He said the research led him to "feel comfortable" determining that there is a finite amount of alpha - conservatively, $30 billion - managed by the approximately $1 trillion hedge fund industry. And even if capital invested in hedge funds were to rise, the amount of alpha would remain the same.... 
Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06.
Here's CBS MoneyWatch in March 2013:
Hedge funds are too big to beat the market
This is probably just a definitional problem so let's say it plainly:

In so called risk (merger) arbitrage the emphasis is on the first word.
Cash-and-carry, buying physical and shorting a derivative is not arbitrage.
When people use the term "arbed away" when talking about market anomalies the are not talking about an arbitrage.
Shorting an ETF and buying the component equities is not an arb, it's just a hedged trade.
Same for Index Arbitrage.

The total pool of arb opportunities may be as small as $1 billion.
Even the old Royal Dutch and Shell Transport trade was not an arb, just a fairly good pair trade.

The link the two commenters were referring to happened to go through this little blog: "VIX, The End of Arbitrage and the Death of Volatility (VIX; VXX; VVIX)".

It linked at Alphaville to some thoughts by Christopher Cole, a hedgie who specializes in volatility trades.
I'm not sure what Steve and Becky do at the market but I'm guessing from their comments that it is not esoteric volatility trades. Read the darn post.

Next up, I'll deal with another commenter.

Here's Professor Hsieih's Hedge Fund Research page.
Here's some smart commentary on the $30 Billion figure.
See also Hsieh's "The Search for Alpha—Sources of Future Hedge Fund Returns", 11page PDF via the CFA Institute.

Two tautologies:
Hedges are not arbitrage, that's why they're called hedges and all hedges are dirty (imperfect).

I'll leave you with a thought from January's "Spot Gold Down $21.80 as HSBC, Credit Suisse Lower Forecasts (GLD)":

...How can one look at that and not think "Gold point arbitrage"?
You have to go to the master, Professor Officer (take that Herr Prof. Dr. Dr.) for the whole scoopage:

Cambridge: Cambridge University Press, 1996, 342 pp.

but one of these days I'll get around to posting on this perfect little arb where J.P. Morgan was willing to accept a measly $1000 profit per $1,000,000 traded because it was an honest-to-goodness arbitrage, not some "hedge", for, as we chant each morning, (all together now) "The only perfect hedge is at Sissinghurst":

If interested see also:
In Which Bloomberg's Matt Levine Goes All "Let's Use Words Correctly, Class" On Us
"Arbitrage: Historical Perspectives"