The Role of Hedge Funds in the Security Price Formation Process
Pennsylvania State University
Texas A&M University - Department of Finance
William N. Goetzmann
Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)
University of Massachusetts Amherst - Department of Finance & Operations Management; China Academy of Financial Research (CAFR)
March 24, 2015
Using a comprehensive dataset of stock holdings by hedge funds, we empirically examine the role of hedge funds in the price formation process. Compared to other institutional investors, hedge funds tend to hold stocks that plot above the security market plane, i.e., undervalued stocks. The sample of undervalued stocks provides a unique setting in which theory makes straightforward predictions about how arbitrageurs should trade and hold mispriced assets, and how their activities should predict future stock returns. We find that in the cross-section of undervalued stocks, hedge fund ownership and trades are positively related to the degree of mispricing and arbitrage cost. A portfolio of undervalued stocks with high hedge fund ownership generates an out-of-sample risk-adjusted return of 0.48% per month, or 5.76% per year. Hedge fund ownership and trades also precede the dissipation of positive alpha. In contrast, all these patterns are nonexistent or much weaker for stocks held by non-hedge fund institutions. The findings are robust to alternative benchmark models and alternative misvaluation measures. Overall, our results suggest that hedge funds exploit and reduce stock mispricing.
Number of Pages in PDF File: 59
Keywords: Hedge funds, stock mispricing, arbitrage cost, investment value
JEL Classification: G11, G23
Date posted: August 2, 2012 ; Last revised: April 24, 2015
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