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Hedge Funds and Stock Price Formation

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

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.A practitioner's perspective on this article is provided in the In Practice piece "Hedge Funds' Influence on Stocks" by Phil Davis, online 9 July 2018. Disclosure: William N. Goetzmann is on the scientific advisory board of a small hedge fund, Zebra Asset Management. Editor’s Note Submitted 16 June 2017 Accepted 23 February 2018 by Stephen J. Brown

Suggested Citation

  • Charles Cao & Yong Chen & William N. Goetzmann & Bing Liang, 2018. "Hedge Funds and Stock Price Formation," Financial Analysts Journal, Taylor & Francis Journals, vol. 74(3), pages 54-68, July.
    • Handle: RePEc:taf:ufajxx:v:74:y:2018:i:3:p:54-68
    DOI: 10.2469/faj.v74.n3.4
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