Do Arbitrageurs Really Avoid High Idiosyncratic Risk Stocks?

23 Pages Posted: 19 Mar 2010 Last revised: 16 Feb 2011

See all articles by Itzhak Ben-David

Itzhak Ben-David

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER)

Denys Glushkov

University of Pennsylvania - The Wharton School, Wharton Research Data Services (WRDS); Acadian Asset Management LLC

Rabih Moussawi

Villanova University - Department of Finance; University of Pennsylvania - The Wharton School

Date Written: March 16, 2010

Abstract

It is widely believed that stocks with high idiosyncratic risk exhibit stronger anomalies because arbitrageurs avoid holding these stocks due to diversification concerns, allowing deviations of prices from fundamental values. In this paper we test this proposition using hedge fund holding data. Controlling for stock size, we find that hedge funds allocate on average more capital towards holding high idiosyncratic stocks than they do towards low idiosyncratic risk stocks. Contrary to the prediction that diversification concerns prevent arbitrageurs from holding high idiosyncratic risk stocks, we find that the effect is stronger for small hedge funds and for less diversified hedge funds, and does not vary with hedge fund leverage. We also find that hedge fund trades in high idiosyncratic risk stocks earn significantly higher abnormal returns than trades in low idiosyncratic risk stocks. We propose that these results can be reconciled by high idiosyncratic risk being a proxy for information noise about the fundamental value. Consistent with this idea, we find that hedge funds require stronger mispricing signals from highly idiosyncratic stocks before trading.

Keywords: limits-to-arbitrage, arbitrageurs, hedge funds, mispricing, diversification, idiosyncratic risk, idiosyncratic volatility, volatility, anomalies, anomaly, frictions, event study, noise, analysts, dividends, signal-to-noise, fundamental value, mispricing, trading,signal

JEL Classification: G11, G12, G14, G23

Suggested Citation

Ben-David, Itzhak and Glushkov, Denys and Moussawi, Rabih, Do Arbitrageurs Really Avoid High Idiosyncratic Risk Stocks? (March 16, 2010). Available at SSRN: https://ssrn.com/abstract=1572955 or http://dx.doi.org/10.2139/ssrn.1572955

Itzhak Ben-David (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Fisher 700D
Columbus, OH 43210-1144
United States
773 988 1353 (Phone)

HOME PAGE: http://fisher.osu.edu/fin/faculty/Ben-David/index.htm

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

HOME PAGE: http://fisher.osu.edu/fin/faculty/Ben-David/

Denys Glushkov

University of Pennsylvania - The Wharton School, Wharton Research Data Services (WRDS) ( email )

WRDS, St. Leonard's Court
3819 Chestnut St, suite 300
Philadelphia, PA 19104
United States
2158986705 (Phone)

HOME PAGE: http://ssrn.com/author=664253

Acadian Asset Management LLC ( email )

260 Franklin Street
Boston, MA 02110
United States

Rabih Moussawi

Villanova University - Department of Finance ( email )

800 E Lancaster Ave
Bartley Hall, 2051
Villanova, PA 19085
United States

HOME PAGE: http://www.homepage.villanova.edu/rabih.moussawi

University of Pennsylvania - The Wharton School ( email )

United States

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