This paper examines the effects of the cross-correlation of stock returns on the long-run post-merger stock performance of UK acquiring firms over the period 1985-2001. In general, it is found that the widely documented anomaly of long-run underperformance following mergers is not due to various stylized merger effects but rather due to the cross-correlation of stock returns, which compromises the `independence of observations' assumption, thus yielding overstated test statistics. The paper in particular tests the method of payment, diversification, book-to-market, and size effects in mergers. It is found that these documented long-run effects simply disappear after accounting for the cross-sectional dependence of sample returns. The results highlight the importance of controlling for the cross-correlation of stock returns in long-run, post-merger event studies.

A large number of studies report that acquiring firms systematically underperform up to five years following mergers. Taken at face value, this finding presents an efficient market anomaly in general and a puzzle for merger activity in particular. In their classic finance textbook, Copeland, Weston, and Shastri (2004, p. 779) postulate that "it (long-run underperformance) represents an anomaly in the sense that it provides an opportunity for a positive abnormal investment return. If acquiring firms always lose after a merger, this suggests that investors (can) short the acquiring firm on a long-term basis at the time of a merger announcement. Of course, over time this anomaly should be wiped out".

But how reliable is the documented long-run post-merger underperformance puzzle? Fama (1998) dismisses most reported long-run anomalies as chance occurrences and shows that these so-called anomalies simply `disappear' with a reasonable change in technique. Over the last decade, studies on long-run post-merger stock performance have benefitted from various methodological improvements. For instance, Agrawal et al. (1992), Loughran and Vijh (1997), and Rau and Vermaelen (1998) employ multifactor models that incorporate size and/or book-to-market factors, which Fama and French (1992 and 1993) show as being better specified than single factor models. However, bad model problems are not the only hurdle in measuring long-run abnormal performance.

Cross-Correlation of Stock Returns, Post-Merger Stock Performance, Mergers, Mergers and Acquisitions, M&A, Securities Data Corporation, SDC, Acquisitions, British Accounting Association, Financial Economics, Stockholder Returns, Corporate Policy.