We analyze the out-of-sample performance of variables shown to forecast future mutual fund alphas. The degree of predictability, as measured by alpha spreads from quintile sorts or cross-sectional regression slopes, falls by at least half post-sample. These declines appear to be primarily the result of changes in the level of arbitrage activity in the market, with mutual fund competition appearing to play a secondary role. We find no evidence that the declines are the result of data snooping or learning by investors or fund managers. Finally, we show that corporate bond fund performance exhibits similar dependence on measures of bond market arbitrage activity.

We develop a model-free measure of the variance premium by constructing option portfolios whose returns are highly correlated with realized stock variance. This effectively decomposes returns into realized variance minus implied variance. We apply this decomposition to document a novel quarterly cross-sectional continuation pattern in both realized variance and implied variance of individual stocks. Implied variance underanticipates the seasonality of realized variance, so options that performed well at quarterly lags continue to earn high returns in the future. Quarterly periodicity in realized stock variance only occurs on days with analyst earning revisions, suggesting an informational channel for this pattern.

Numerous trading strategies examined in options research exhibit remarkably high mean returns and Sharpe ratios. We show some of these seemingly “good deals” are due to look-ahead biases. These biases stem from using information unavailable at the portfolio formation time to filter out observations suspected of being noisy or erroneous. Our results suggest that elevated Sharpe ratios may serve as potential indicators of such look-ahead biases. Furthermore, deviating from previous literature findings, we show that illiquidity is not strongly priced in stock options and that only a small set of stock characteristics are in fact associated with option expected returns.