Hedge funds and stock price formation

Charles Cao, Yong Chen, William N. Goetzmann, Bing Liang

Research output: Contribution to journalArticlepeer-review

5 Scopus citations

Abstract

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 trading by hedge funds 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.

Original languageEnglish (US)
Pages (from-to)54-68
Number of pages15
JournalFinancial Analysts Journal
Volume74
Issue number3
DOIs
StatePublished - 2018

All Science Journal Classification (ASJC) codes

  • Accounting
  • Finance
  • Economics and Econometrics

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