Financial Analysts Journal 2 July 2018 Volume 74 Issue 3
Hedge Funds and Stock Price Formation
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 is Smeal Chair Professor of Finance at Smeal College of Business, Pennsylvania State University, University Park, Pennsylvania.
Yong Chen is associate professor of finance at Mays Business School, Texas A&M University, College Station, Texas.
William N. Goetzmann is the Edwin J. Beinecke Professor of Finance and Management Studies and director of the International Center for Finance at the Yale School of Management. He teaches portfolio management, alternative investments, real estate, and financial history and is an expert on a diverse range of investments. Professor Goetzmann’s past work includes studies of stock market predictability, hedge funds, and survival biases in performance measurement. His current research focuses on alternative investing, factor investing, behavioral finance, and the art market. Professor Goetzmann has written and co-authored a number of books, including Modern Portfolio Theory and Investment Analysis; The Origins of Value: The Financial Innovations That Created Modern Capital Markets; The Great Mirror of Folly: Finance, Culture, and the Crash of 1720; and most recently, Money Changes Everything: How Finance Made Civilization Possible.
Bing Liang is Charles P. McQuaid professor of finance at Isenberg School of Management, University of Massachusetts Amherst, Amherst, Massachusetts.