Overcoming The Limits Of Arbitrage

by: Arete Asset Management

The concept of arbitrage is normally applied to financial securities, but can also be applied more broadly to situations involving imbalances.

Investment services have been rife with imbalances between what investors want/need and what is commonly offered by vendors.

"Cutting the cord" serves as a useful model for how investors can arbitrage high recurring fees from investment service providers.

In 1986, Andrei Shleifer and Robert Vishny published a classic finance article entitled, "The Limits of Arbitrage". The two academics made the case [here] that "prices may remain in a non-equilibrium state for protracted periods of time". This can happen because of "restrictions that are placed on funds that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies."

Although arbitrage is a concept normally reserved for finance, it is also much more broadly applicable. In a general sense, arbitrage is an activity that can prevent extremes from occurring. This is useful to keep in mind because many goods and services are priced higher than they would be if market mechanisms functioned properly. The bad news is that many investment services fall into this category. The good news is that arbitrage, and overcoming the limits to it, can provide a path to better outcomes.

For certain, we all have these experiences with things that cost way more than we think they should. I had such an experience a few weeks ago when I took my car in to the dealer for some repair work. During the visit, I asked if they could also take a look at the driver's side window which had not been working properly. Although I anticipated the dealer would be more expensive than other alternatives, I also figured it would be worth saving time to find an alternative.

Boy was I wrong! I got a call on the status of the work a few hours later and also got a quote on the window for $539! I was stunned. I expected it to be high but not ridiculous. Although shocked by what I considered an outrageous quote, I said I would think about it and get back to them.

After a couple of deep breaths to calm down, my analytical self kicked into gear and searched Google for window problems with my car. I immediately found a short video that highlighted the same problem I was having. A bad drive gear in the motor assembly appeared to be the culprit. Next, I searched for how to replace the motor assembly and immediately found a 12-minute video that showed exactly how to do it on my car. It wasn't a simple operation, but it was well within my skill set. The next search was on Amazon (NASDAQ:AMZN) for the replacement gear. It cost $10 and through Amazon Prime would arrive in two days. I ordered it.

With a solid alternative plan now firmly in place, I called the dealer back and informed them that I would not be having them do the work on the window. After I got the car back and received the replacement gear, I followed the online video, removed the motor assembly, replaced the gear, and reattached the door panel. I tested the window and everything worked perfectly! I actually tested it several times just to savor the moment.

Now, there were several levels on which this was a gratifying experience. For one, the window had been a problem for a while, and it was just nice to have it done. For another, there was a nice sense of accomplishment from producing such a tangible benefit. Importantly, I also saved a lot of money. The main reason I was so happy with the results, however, was that I felt like I was able to thwart the dealer's attempt to take advantage of me.

It turns out that such intolerance of unfairness is pretty common. As Jonathan Haidt argues in his book, The Righteous Mind, righteousness arises from "an outraged sense of justice, morality, or fair play" and obsession with it is "the normal human condition." Regardless of the time or place, it seems, unfairness tends to get people fired up.

One great example that many people can relate to is the cable television industry. These companies have leveraged local monopolies by forcing bundles of largely unwanted channels on customers and by persistently raising rates each year. They top it all off with disastrously bad customer service. Despite the outrage these practices have engendered, viewers have had little recourse because until recently no good substitutes existed.

When such a large gap exists between what providers deliver and what consumers actually want, there is often an arbitrage opportunity. The reason is that the bigger the disparity, the less perfect a substitute needs to be in order to suffice as a superior alternative. In my case with the car, the degree of my aversion to fixing the window myself was far less than my aversion to overpaying the dealer to do so. In the case of cable television, "cutting the cord" has been less problematic for many people than continuing to overpay cable companies.

Not every situation lends itself to arbitrage, however, and sometimes, intentional efforts are made to undermine the option of finding substitutes, especially by way of making a repair. As the Economist highlighted [here], in regards to various devices, including washing machines, coffee makers, and even toys, "All are becoming exceedingly difficult to fix - which has given rise to a movement fighting for a 'right to repair'."

In many cases, technology can serve as a facilitator. In my situation fixing the car, technology helped in identifying a couple of key tidbits of information that I needed through an online video and by being able to quickly and cheaply acquire the replacement part through Amazon. In the case of video entertainment, technology provides a new distribution platform by enabling video to be streamed through various devices.

Technology is not an unalloyed good, however; it can also impede efforts to arbitrage a better outcome. Some of this is inadvertent and simply a function of rapidly improving technology. For example, the popularity of mobile devices has spurred a great deal of miniaturization of component parts that cannot be fixed in a cost effective manner. Even many larger goods (the article mentioned farm tractors) are so permeated with electronics and software that they are beyond the reach of amateurs to repair.

This is all very relevant for investors because investment services is one business in which there have typically been large disparities between what people want/need and what is offered. Most visibly, the industry has been tainted by high costs, but undue complexity and lack of transparency have also played prominent roles in creating barriers to the cost-effective delivery of investment services.

To be sure, a number of developments over the last 30 years or so have been quite beneficial for investors. The emergence of discount brokers and the downward trend of commissions have made trading much cheaper, index funds have made diversified exposure to the market much cheaper, and lower costs for computing power, data, and research have expanded accessibility to the basic tools of investment analysis. Somewhat remarkably, however, investor outcomes have not significantly improved despite these advances.

What these advances have done is to increasingly provide opportunities to arbitrage expensive or unwieldy services. A prominent example is the transition of funds from actively managed strategies to passive ones. While passive strategies are imperfect substitutes for active ones, they can be cost-effective substitutes for investors who only want general exposure to the markets, don't require the insights or risk management skills of investment professionals, and have very long investment horizons.

It's not just active management fees that have tended to be excessive, but advisory fees too. A recent story [here] listing the highest cost advisers shows that this sphere of investment services is also ripe for arbitrage opportunities. The most common form to date has been do-it-yourself (DIY) investors who use access to widely available investment information as a foundation for making their own investment decisions. This approach can be cost effective but also requires a great deal of effort and is normally lacking in investment expertise.

Even as these opportunities avail themselves, investors would do well to keep the big picture in mind. In this respect, the massive shortfall of financial assets relative to financial liabilities is the granddaddy of all investment challenges. As John Dizard states bluntly in the Financial Times [here], "[The] financial world's promises are statistically impossible to meet." In other words, even though stocks and bonds have been going up, the debts and liabilities offsetting them have been growing even faster.

This underappreciated reality has significant implications for investors. It is not nearly enough to content oneself with gently rising asset values; that is only part of the equation. In order to accomplish anything close to financial security, investors must juggle the multiple challenges of getting the most out of financial assets, incorporating non-financial assets, and constantly managing downside risk. And, they need to do all of this as cost-effectively as possible.

In this quest, it makes sense for investors to consider the playbook of video consumers "cutting the cord". When recurring fees are high, an effective substitute can be created by cobbling together some leaner but cheaper services and periodically supplementing them with requisite expertise. While this may seem like an unusual approach to investing, it also happens to be exactly how we normally manage our physical health. We take care of ourselves on a regular basis and periodically see a doctor when we have a more serious health problem. There is no good economic reason that the exercise of investing should not also make more selective use of relevant expertise.

In sum, arbitrage can be a very fruitful response to offerings that don't provide good value. Although many producers seek to create limits to arbitrage opportunities, it is very difficult to protect unfair or abusive practices indefinitely, so persistence pays off. Further, in addition to providing economic benefits, pursuing better deals through arbitrage also provides psychic benefits because it feels good to have a greater sense of control over one's own fate.

Finally, Jonathan Haidt provided some valuable perspective in describing his own intellectual journey in regards to moralism and righteousness. He noted, "When I was a teenager, I wished for world peace." But with greater experience and maturity, he says, "now, I yearn for a world in which competing ideologies are kept in balance ..." Indeed, balance is what the activity of arbitrage accomplishes, and that is usually a good thing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.