Hedge Funds and Stock Market Efficiency

Forthcoming in Management Science

25 Pages Posted: 21 Aug 2012 Last revised: 12 Oct 2017

Joni Kokkonen

Catolica-Lisbon School of Business and Economics

Matti Suominen

Aalto University School of Business

Date Written: August 21, 2012

Abstract

We measure misvaluation using the discounted residual income model. Confirming the findings in the literature, we show that there are significant returns on a misvaluation based long-short portfolio that buys under- and sells short overvalued shares. We define misvaluation spread as the difference in the misvaluation of over- and undervalued shares. We show that this measure is a strong predictor of the misvaluation based long-short portfolio’s returns, reinforcing our hypothesis that it proxies for the overall level of mispricing in the stock market. Our main finding is that hedge fund industry flows significantly reduce the misvaluation spread: one standard deviation increase in flows is associated on average with a 2.5% decrease in the misvaluation spread. We find that this effect comes solely from hedge funds exposure to undervalued shares: hedge fund flows reduce the undervaluation of undervalued shares, but not the overvaluation of overvalued shares.

Keywords: Hedge funds, mispricing, stock market, market efficiency

JEL Classification: G11, G12, G14, G23

Suggested Citation

Kokkonen, Joni and Suominen, Matti, Hedge Funds and Stock Market Efficiency (August 21, 2012). Forthcoming in Management Science. Available at SSRN: https://ssrn.com/abstract=2133394 or http://dx.doi.org/10.2139/ssrn.2133394

Joni Kokkonen

Catolica-Lisbon School of Business and Economics ( email )

Palma de Cima
Lisbon, 1649-023
Portugal

Matti Suominen (Contact Author)

Aalto University School of Business ( email )

PO Box 1210
FI-00101 Helsinki
Finland
+358-50-5245678 (Phone)

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