Hedge Funds and Stock Price Formation

Abstract

Using comprehensive quarterly data on hedge fund stock holdings, we study the role of hedge funds in the process of stock price formation. We find that hedge funds tend to hold undervalued stocks, and that both hedge fund ownership and their trades are positively related to the degree of stock mispricing. A portfolio consisting of undervalued stocks with high hedge fund ownership generates a risk-adjusted return of 0.40% per month (or, 4.8% annually), and the profit stands even after transaction costs. Hedge fund ownership and trades also precede the dissipation of stock mispricing. In contrast, these patterns are either nonexistent or much weaker for other types of institutional investors. Taken together, our results suggest that hedge funds exploit and help correct mispricing, but the process is not instantaneous.

Keywords: Hedge funds, stock holdings, stock mispricing, investment value, arbitrage

JEL Classification: G11, G23