There Is a HUGE Inefficiency In The Stock Market

Quant Galore
5 min readDec 29, 2022

Something is seriously messed up in the markets.

Background

Let’s quickly go over some background knowledge that will allow you to understand the inefficiency.

Companies sometimes go public offering two classes of shares. Using Google for example, the Class A shares are represented by the ticker symbol(“GOOGL”) and the Class C shares are represented by the ticker symbol (“GOOG”). As is usually the case, this dual-listing is done so that the founders can retain disproportionate ownership of the company while still being public. Class A shares typically hold more voting rights, so founders and initial investors are usually the largest holders.

Because of this voting right advantage, Class A shares may cost more than Class C shares (e.g. Class A = $100, Class C = $99.75), this is normal and in line with expectations. However, both shares represent the same company and both shares usually have identical market capitalizations as there are no other differences.

So the big picture idea is: Class A shares should always cost more than the other classes of the same stock. For the interested, see these papers which also observe the same effect:

The Inefficiency

Normally, this relationship is pretty predictable, and in line with what we’d expect:

Left: Google, Right: News Corporation
Left: Under Armour, Right: Zillow

Note: Vote Premium is calculated by: (Class A cost — Class C cost).

This makes sense, if you get more voting privileges, then those privileged shares should be worth more. But how does this relationship fare in times of trouble?

Left: Google | Right: News Corporation
Left: Under Armour | Right: Zillow

But intuitively, this makes sense — in times of distress, liquidity matters most, so as selling pressure increases, the premium can temporarily swing negative, or at least it goes down significantly.

That makes sense.

So then why is it going down now?:

Left: Google | Right: News Corporation
Left: Under Armour | Right: Zillow

We only see the premium go negative in instances where volatility is high and liquidity is needed, but as shown, the premium has been negative (or much lower) for the entire latter-half of the year.

There are a few possibilities as to why this is the case:

Main Theory

  • 2022 was indeed a volatile year, and there are concerns about growth for 2023. By the shares not having a premium, the market is saying that right now liquidity is more valuable than the voting rights. That relationship may change, but right now, liquidity is more important than owning voting rights in the underlying stock.

This theory is the most intuitive and appears to be the most probable. So if true, this can be exploited in two ways:

  • 1) Assume the difference is temporary and put on an arbitrage position. I go more into detail on the specifics of putting on this trade here, but the way to capture this would be by buying the Class A share and shorting the Class C share. You are betting that the relationship will go back to normal, and as such, the Class A shares will be worth more than the Class C shares. You are market neutral and only profit when the relationship goes back to normal.
  • 2) This may be an early warning indicator. Usually when the premium goes negative, it bounces right back in line, but it’s been out of whack for a few months now. This can imply that: a) institutions have been leaving the market at a such a rapid pace that created the imbalance or b) since the premium in almost all dual-listed stocks are still negative right now, it might mean that the liquidity demand is still not being met.

2b is the worst case scenario. The optimist in me wants to bet on the premium coming back and this effect only being temporary, but why has it lasted this long?

The voting premium has vanished and went negative in almost every dual-listed stock in the market. You can see this right now (assuming Dec. 2022) by just looking up the price difference of any pair (e.g. “GOOGL” for Class A (voting rights) and “GOOG” Class C(no voting rights).

GOOG (right) should rarely cost more than GOOGL (left)

In times of low liquidity, volatility goes up. But not all volatility is bad. This might even indicate that when institutions plan to return back into these positions, the low-liquidity will cause a heavy rally. Either way, both signal increasing volatility, so the best option right now may just be a 30-Day VIX call option for insurance. To understand why I think this may be the best option, visit here.

It will definitely be interesting to see how this plays out.

If this piqued your interest and you’d like to read more like it, head over to The Quant’s Playbook where I do deep dives into actionable market exploits and opportunities.

Happy trading!

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Quant Galore

Finance, Math, and Code. Why settle for less? @ The Quant's Playbook on Substack