The persistence of asset pricing anomalies—predictable patterns in stock returns that deviate from standard capital asset pricing models—has long been a subject of debate between the behavioral and rational schools of finance. However, the research conducted by Chu, Hirshleifer, and Ma provides the most compelling causal evidence to date that these anomalies are primarily driven by mispricing sustained by limits to arbitrage. The central finding is that when short-selling constraints are relaxed, the profitability of these anomalies significantly diminishes, suggesting that the inability of sophisticated investors to bet against overvalued stocks is the primary mechanism allowing these inefficiencies to persist.
The researchers utilized a quasi-natural experiment provided by the Securities and Exchange Commission’s Regulation SHO, which commenced in May 2005. This regulation created a pilot program that removed short-sale price tests, such as the uptick rule, for a designated group of one-third of the stocks in the Russell 3000 index. By comparing this pilot group to a control group of stocks that remained subject to short-sale restrictions until the pilot ended in August 2007, the study isolated the causal effect of short-sale constraints on market efficiency. This methodology allowed the researchers to move beyond simple correlation and demonstrate that the friction itself was the variable sustaining the anomaly.
The quantitative impact of this regulatory shift was substantial. The study examined a composite of 11 prominent anomalies, including the accrual effect, net stock issues, momentum, and asset growth. For the stocks in the pilot group where short-selling was made easier, the average long-short return of these anomalies decreased by approximately 56 basis points per month. On an annualized basis, this represents a reduction in excess returns of roughly 6.7%. This decay in alpha was driven almost entirely by the short leg of the portfolios; as short-selling became less restricted, the prices of overvalued stocks corrected downward more efficiently, thereby narrowing the return gap between the long and short positions.
This mechanism challenges the traditional rational-markets hypothesis, which posits that anomalies represent compensation for bearing hidden risk factors. If these anomalies were truly risk-based, a change in the technical rules governing short-selling should have had no impact on the expected returns. The fact that the returns collapsed when the friction was removed confirms that the anomalies were the result of overvaluation that arbitrageurs were previously unable to exploit. This aligns with the historical context of the 1963 to 2013 period, where anomalies have been observed to be strongest in small-cap stocks and those with high idiosyncratic volatility—segments where the costs and risks of shorting are traditionally highest.
For institutional investors and portfolio managers, these findings have profound practical implications. First, they suggest that the capacity of any anomaly-based strategy is strictly limited by the liquidity and borrow-availability of the underlying securities. As market infrastructure evolves and shorting costs decline through technological and regulatory changes, the historical alpha associated with these factors is likely to undergo permanent compression. Managers must distinguish between alpha derived from genuine insight and alpha that is merely a harvestable premium for navigating market frictions.
Furthermore, the research highlights the necessity of monitoring regulatory environments as a core component of risk management. The sudden removal of a market friction can lead to a rapid re-pricing of factor exposures, potentially causing significant drawdowns for quantitative strategies that rely on the persistence of mispricing. In the current market of 2026, where electronic front-running and high-frequency arbitrage have already tightened spreads, the lessons from the Regulation SHO era remain a critical reminder that market efficiency is not a static state, but a dynamic equilibrium maintained by the relative ease of arbitrage.