The Buzzard Was Their Friend – Hedge Funds and the Problem of Overvalued Equity

Abstract

Hedge funds – unregistered investment companies – were identified as one of many possible contributing causes of the 2008 financial crisis. Some critics worried that hedge funds had garnered too much market power, while others worried that sponsorship of hedge funds by commercial banks may have induced the assumption of too much risk. The fact that hedge funds often engage in various forms of short selling – in effect betting that markets prices will decline – also added to the suspicion. Some observers suggested that because some hedge funds profited handsomely from the collapse of the housing bubble, they somehow caused the credit crisis. On the other hand, since it has become increasingly easy to place such bets using various derivative instruments, it seems likely that the influence of hedge funds has increased in recent years. All of these worries were exacerbated by the fact that hedge funds and their advisers are exempt from most forms of federal regulation and thus are able to operate largely in secrecy.

Worries about the power and influence of hedge funds may obscure their vital role in keeping the capital markets efficient. Commentators have long recognized that the efficient market theory is paradoxical. If investors believe that the market is efficient, no one will trade, and the market will quickly become inefficient. Thus, the efficient market theory depends on traders who reject it. While this paradox may be more apparent than real, it illustrates the importance of traders who seek to identify misvalued securities. In other words, stock-pickers are essential to the price discovery process.

Moreover, some have suggested that equity compensation (broadly conceived) may have been another contributing cause of the financial crisis. Although it seems unlikely that equity compensation induces excessive risk – since it is just as likely to result in losses as gains – and since CEOs tend to be more risk averse than investors who can and do diversify – it is possible that equity compensation may prompt CEOs to adopt questionable strategies to prevent decreases in stock price. Thus, the market may be biased upward by compensation practices in addition to traditional restrictions on short selling.

In this article, I attempt to estimate the importance of hedge funds relative to other participants in keeping the stock market efficient. It is surprisingly difficult to find good data about who trades and why. But by piecing together data from multiple sources, I find that hedge funds appear to account for about 15% of trading. More important, little of the other 85% of trading appears to involve any significant effort to identify misvalued stocks. About 41% of volume is attributable to market makers (including specialists) and program trading. While institutional investors account for 34% of trading, most institutional investors are legally and practically prevented from going short or engaging in significant stock-picking. The bottom line is that hedge funds appear to play a vital role in keeping the markets efficient.

Keywords: credit crisis, derivatives, efficient market theory, efficiency paradox, equity compensation, free rider, futures, hedge fund, housing bubble, index fund, informed trading, institutional investor, market maker, options, portfolio balancing, price discovery, program trading, short sale, stock-picking

JEL Classification: E44, G14, G2, K22, M52