What it means
Classical theory says that if a price drifts away from fundamental value, well-funded traders will buy or sell until the gap closes, so prices are always about right. Shleifer and his co-authors pointed out that real arbitrageurs are specialists running other people's money, which changes the picture completely.
A fund that spots a mispricing faces two separate risks: the risk that it is wrong, and the risk that the price moves further against it before converging. Because the fund borrows and faces investor withdrawals, a widening gap can force it to sell at the worst moment, which pushes the price further from value rather than closer to it.
The related noise trader work, written with Bradford De Long, Lawrence Summers and Robert Waldmann, showed that traders who buy and sell for reasons unrelated to fundamentals can move prices and survive. That is why sentiment can dominate a market for months and why being right early is not the same as making money.
Shleifer also contributed to the law and finance literature, which examines how investor protection, enforcement quality and company law affect the depth of a country's capital markets. The practical reading is that where a business lists or raises money depends on more than the valuation multiple on offer.
None of this argues that markets are useless. The argument is about frictions: funding, borrowing limits and the horizon of the people with capital.
For a practitioner the takeaway is to size positions so that being right too early does not become fatal.
In practice
Real-world examples.
Example
A hedge fund identifies a closed-end fund trading 20% below the value of the assets it holds and buys in. The discount widens to 28% over the next quarter, investors withdraw money, and the fund closes the position at a loss before the discount finally narrows.
Example
The founder of a listed engineering group watches his shares trade below the book value of the company's property. No large buyer steps in, because the shares are thinly traded and a fund cannot build a position without moving the price, so the gap persists for years.
Example
A pension trustee reviewing an arbitrage strategy asks how the manager is funded and how quickly investors can withdraw. The answers tell her more about the real risk than the historic return series does.
Formula
Calculation
There is no single formula bearing his name, but the funding risk at the centre of the limits of arbitrage can be shown with a margin calculation:
Required equity = Position value x Margin requirement
A fund believes a share worth $100 is mispriced at $80 and buys 100,000 shares for 100,000 x $80 = $8,000,000, funding $4,000,000 from its own capital and borrowing $4,000,000 from its broker under a 50% margin requirement. The price then falls to $70, so the position is worth 100,000 x $70 = $7,000,000 and the fund's equity is $7,000,000 - $4,000,000 = $3,000,000. Required equity is now $7,000,000 x 0.50 = $3,500,000, so the broker calls for $3,500,000 - $3,000,000 = $500,000. If the fund cannot raise that cash it is forced to sell at $70, crystallising a loss of ($80 - $70) x 100,000 = $1,000,000 on a position whose analysis may well have been correct.Case study
Seen in the real world.
Kestrel Point Capital is an illustrative, fictional fund that spotted two shares in the same industry trading at very different multiples on nearly identical earnings. It bought the cheap one and sold the expensive one, expecting the gap to close within a year.
For seven months the gap widened instead. The fund was borrowing to hold both legs, two large investors gave notice of withdrawal, and the manager had to unwind at the widest point of the spread for an illustrative loss of $6,000,000. The valuation gap closed four months later, almost exactly as the original analysis had predicted.
The fictional post-mortem is the lesson this concept teaches: the analysis was right and the funding was wrong. The fund's redesigned mandate halved position sizes, extended investor lock-ups and set aside a cash reserve specifically for margin calls, so that a correct view would have time to be proved correct.
Watch out
Common mistakes.
- Assuming a visible mispricing will correct quickly, when funding limits and investor behaviour can keep a gap open for years.
- Treating a correct valuation view as a profitable trade without planning for the cash needed if the price moves against you first.
- Reading behavioural finance as proof that markets never work, when the argument is about specific frictions rather than general chaos.
Questions
People also ask.
Who is Andrei Shleifer?
A Harvard economist known for the limits of arbitrage, noise trader models and research on how legal systems affect financial markets.
What are the limits of arbitrage?
The practical constraints, mainly borrowing limits, margin calls and investor withdrawals, that stop professional traders from correcting a mispricing they can clearly see.
Why does this matter outside a trading desk?
Because it explains why a well-run private company can stay cheap, why sentiment can dominate a market for long stretches, and why position sizing matters as much as analysis.
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