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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 of undervalued stocks with high hedge fund ownership generated a risk-adjusted return of 0.40% per month (4.8% annually), and the profit remained even after transaction costs. Hedge fund ownership and trades also precede the dissipation of stock mispricing. These patterns are either nonexistent or much weaker for other institutional investors. Our results suggest that hedge funds exploit and help correct mispricing but the process is not instantaneous.

About the Author(s)

Charles Cao

Charles Cao is Smeal Chair Professor of Finance at Smeal College of Business, Pennsylvania State University, University Park, Pennsylvania.

Yong Chen

Yong Chen is associate professor of finance at Mays Business School, Texas A&M University, College Station, Texas.

William N. Goetzmann
William N. Goetzmann

William N. Goetzmann is Edwin J. Beinecke Professor of Finance and Management Studies and director of the International Center for Finance at Yale School of Management, New Haven, Connecticut.

Bing Liang

Bing Liang is Charles P. McQuaid professor of finance at Isenberg School of Management, University of Massachusetts Amherst, Amherst, Massachusetts.