Shorting opaque signals

Abstract

This study uses short interest data to show that quantitative equity investors devote more capital to firm-specific arbitrage strategies in stocks with more opaque earnings. There are also higher strategy returns in stocks with opaque earnings. Together, these results suggest that quantitative investors exploit their sophistication by trading when the firm's earnings make it more costly for other market participants to understand the future implications of a signal. The result is stronger for fundamental-based strategies such as post-earnings-announcement drift than for market-based strategies such as return momentum, suggesting that arbitrageurs shift capital from market strategies to fundamental strategies when earnings are opaque. Overall, the paper highlights the role of sophisticated quantitative investors in impounding signals that are difficult to understand into prices and suggests that the opacity of a firm's fundamentals is a key determinant of sophisticated investors' trading strategies.