Hedge Funds and Stock Price Formation

30 Pages Posted: 2 Aug 2012 Last revised: 16 Aug 2018

See all articles by Charles Cao

Charles Cao

Pennsylvania State University

Yong Chen

Texas A&M University - Department of Finance

William N. Goetzmann

Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Bing Liang

University of Massachusetts Amherst - Department of Finance

Date Written: April 6, 2018

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

Suggested Citation

Cao, Charles and Chen, Yong and Goetzmann, William N. and Liang, Bing, Hedge Funds and Stock Price Formation (April 6, 2018). Financial Analysts Journal, Vol. 74, No. 3, 2018, pp. 54–69. Available at SSRN: https://ssrn.com/abstract=2121495 or http://dx.doi.org/10.2139/ssrn.2121495

Charles Cao

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

Yong Chen

Texas A&M University - Department of Finance ( email )

360 Wehner Building
College Station, TX 77843-4218
United States

William N. Goetzmann

Yale School of Management - International Center for Finance ( email )

165 Whitney Ave.
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5950 (Phone)
203-436-9252 (Fax)

HOME PAGE: http://viking.som.yale.edu

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Bing Liang (Contact Author)

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States

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