Monday, August 21, 2006

Economic Links for Arbitrage

A recently released paper from Lauren Cohen and Andrea Frazzini finds a system of arbitrage that has apparently gone unnoticed for a significant amount of time. The authors’ “customer momentum” portfolio manages to return 18% per year.

How? Customer and supplier links. The authors explain that they “…simply follow the evolution of customer/supplier firm-specific relations over time.” Their easy example of such a relationship were the companies Coastcast (gold club heads) and Callaway (golf equipment retail company). Essentially, the authors take customer/supplier link firms that have significant business with each other (which ends up being 11,484 unique relationships between 1980 and 2004).

And here is an explanation of how the arbitrage works:

In this example, we were unable to find any salient news release about Coastcast other than the announcement of a drop in revenue of its major customer. However, it was not until two months later the price of Coastcast adjusted to the new information. A strategy that would have shorted Coastcast on news of Callaway’s slowing demand would have generated a return of 20% over the subsequent two months.

To make this work though, time is needed to assemble the information on companies that are linked significantly. And then it would be up to the person managing the portfolio to hound for news articles and press releases for all those companies, and then execute the strategy accordingly.

Cohen and Frazzini made a believer out of me; the strategy is sound. I just wonder to what extent fund managers use this type of arbitrage because “78% of the customer-supplier link relationships are in fact across industries, so industry momentum is unlikely to be driving the results.”
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