Do hedge funds have an edge over other institutional investors? Can their trading activity actually move markets? The authors set out to separate myth from reality.

These questions have added urgency because of the launch by Goldman Sachs of an exchange-traded fund (ETF) that tracks the performance of the Goldman Sachs hedge fund index, the VIP. The VIP, composed of fundamental hedge fund managers’ top long equity holdings, has outperformed the S&P 500 Index by an average of more than 2% a year since the index was created in 2001.

The authors seek to verify whether stocks held by hedge funds consistently outperform and whether hedge funds, as a group, can really exploit and correct price inefficiencies in the stock market.

Using quarterly SEC 13F filings data on hedge fund stock holdings, the authors create a dataset of US stock holdings from some 1,517 hedge fund management companies over the period 1981–2015.

Two main aims are identified for research into stocks held by hedge funds:

1. Do hedge funds actually have a tendency to invest in undervalued stocks that have positive alphas? The authors define a positive-alpha stock as one that tracks above returns from the broader market.They test whether hedge fund ownership of positive-alpha stocks is related to the mispricing of those stocks.
2. Can hedge fund trading in positive-alpha stocks predict future stock returns? The authors examine whether hedge funds can generate excess returns in their portfolios by investing in undervalued stocks and whether their trading activity reduces mispricing.

The findings confirm that fundamentally oriented hedge funds, on average, consistently unearth alpha during the period studied in US markets.

Hedge funds are able to exploit mispricing to create alpha in their portfolios and for underlying clients. A portfolio of undervalued stocks that had above-average hedge fund ownership produced alpha of 0.40% a month, or 4.8% a year. This added value was still present after transaction costs because such a portfolio of stocks with a high hedge fund ownership needs only quarterly rebalancing and the stocks traded are relatively liquid.

The authors find that hedge funds, compared with other financial institutions, make higher allocations to small, growth, young, and low-priced stocks, as well as to stocks not listed in the S&P 500.

Hedge fund trading activity tends to rise with greater degrees of stock mispricing. Stocks with a larger alpha in one quarter are correlated with significantly higher ownership by fundamental hedge funds in the next quarter.

Moreover, undervalued stocks that are bought by hedge funds in one quarter are more likely than stocks held by other investors to see their mispricing by markets corrected in the next quarter. This finding suggests that hedge funds help correct mispricing, even if the price correction is not immediate.

On the issue of whether hedge fund trading activity can predict the direction of stock returns, stocks with high hedge fund ownership and trading activity, on average, generate substantially higher returns than stocks associated with low hedge fund ownership and trading activity. This is the case even after taking into account risk exposures and transaction costs.

Lastly, the authors find that stock mispricing is reduced after the intervention of hedge funds. That is, alpha that exists in one quarter disappears or lessens in the next quarter if the stock is held by hedge funds. 

The authors show that hedge fund investments, when rebalanced quarterly, are linked to the subsequent rerating by the market of mispriced stocks.

Fundamental hedge fund strategies must be able to demonstrate that they can offer value for money after fees and transaction costs against competitors using cheaper hedge fund replication strategies and quant and factor-based techniques.

This article seems to confirm they can successfully exploit inefficiencies in stock prices and produce significant value. The authors detect substantial differences in the way that equity holdings are analysed by hedge funds and other institutional investors.

The results suggest that hedge funds, as a group, can successfully pursue arbitrage opportunities in stock markets and are better at doing so than other categories of investor.

A caveat to this research is that the data are reported at the stock level, not the fund level; that is, the authors could not examine which hedge fund strategies were better (or worse) at exploiting inefficiencies. This leaves open the possibility that activist hedge funds, which lobby hard for change at investee companies, play an outsize role in finding and correcting stock undervaluation. Given that activist strategies represent only 4% of the hedge fund universe, they probably do not significantly skew the findings.