Do Hedge Funds Ride Market Irrationality?
62 Pages Posted: 12 Apr 2018 Last revised: 23 Feb 2019
Date Written: August 1, 2017
We document empirical evidence that hedge funds temporarily ride rather than attack high market irrationality but they neither ride irrationality in long run nor ride during low irrationality periods. Irrationality-riding funds outperform irrationality-attacking funds by 4.4% per year on a risk-adjusted basis. The outperformance should be attributed to funds’ irrationality-riding strategy during the formation period of the tech bubble, and the bursting period of the housing bubble. The findings are consistent with the behavioral theories that sophisticated investors ride rather than attack unsophisticated investors’ strong misperception. Finally, we do not find that mutual funds have irrationality-riding ability.
Keywords: hedge funds, noise trader, irrationality riding, arbitrage
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