Arbitrage Trading : The Long and the Short of It

We examine net arbitrage trading (NAT) measured by the difference between quarterly abnormal hedge fund holdings and abnormal short interest. NAT strongly predicts stock returns in the cross section. Across 10 well-known stock anomalies, abnormal returns are realized only among stocks experiencing large NAT. Exploiting Regulation SHO that facilitated short-selling for a random group of stocks, we present causal evidence that NAT has stronger return predictability among stocks facing greater limits-to-arbitrage. We also find large returns for anomalies that arbitrageurs chose to exploit despite capital constraints during the 2007-2009 financial crisis. Finally, we confirm our main findings using daily data