Swedroe: Hedge Funds & Undervalued Stocks

Hedge funds help with price discovery, but fees severely dent their excess returns.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

Charles Cao, Yong Chen, William Goetzmann and Bing Liang contribute to the literature on hedge funds with their study “Hedge Funds and Stock Price Formation,” which appears in the third quarter 2018 edition of the Financial Analysts Journal.

The focus of their study was to determine if hedge funds, as a group, exploit and correct price inefficiencies in the stock market. Using the long-position data (long positions target what the buyer perceives to be undervalued stocks), they studied the role of hedge funds in the stock price formation process.

Note that because the SEC does not require institutions to disclose their short positions (which seek overvalued stocks), their analysis focused on the long positions and positive-alpha stocks. Their data set consisted of stock holdings of 1,517 hedge fund management companies over the period 1981 through 2015. The SEC requires hedge fund companies with more than $100 million in assets under management to file quarterly disclosures of equity holdings. Thus, portfolios were rebalanced quarterly, which has the benefit of controlling trading costs.

Study Results

Following is a summary of their findings:

  • By 2015, hedge funds controlled 16.4% of shares held by all institutions, while mutual funds and banks controlled 39.2% and 14.4%, respectively.
  • Stocks with high hedge fund ownership have lower dividend yields, younger age and a lower percentage of the S&P 500 Index membership in comparison with the full sample.
  • Hedge funds tend to hold undervalued stocks—stocks that go on to outperform, generating alpha relative to the Fama-French four-factor (beta, size, value and momentum) model—and thus are able to identify mispricings.
  • Undervalued stocks, relative to stocks with insignificant alphas, are associated with higher hedge fund ownership (statistically significant at the 1% confidence level).
  • Hedge fund ownership is not significantly related to negative-alpha stocks.
  • Both hedge fund ownership and trades are positively related to the degree of mispricing—hedge funds increase their purchases with the degree of underpricing, but this is not the case for nonhedge funds. A portfolio of positive-alpha stocks with high hedge fund ownership realizes a risk-adjusted return of 0.40% (t-statistic = 3.36) per month, about 4.8% per year, significantly outperforming a counterpart portfolio of positive-alpha stocks with low hedge fund ownership (0.02% per month; t-statistic = 0.16). Importantly, the outperformers were not less liquid stocks—trading costs were manageable and easily implementable. And the alpha exceeds conventional estimates of trading cost. And these are long-only portfolios, avoiding the high costs often associated with shorting. Although the high ownership portfolio has higher return volatility, it exhibits a higher Sharpe ratio.
  • A portfolio with large hedge fund trades significantly outperforms a portfolio with small trades. For example, the large trade portfolio shows an alpha of 0.36% (t-statistic = 3.21) per month, significantly higher than the alpha of 0.04% (t-statistic = 0.32) per month for the small trade portfolio. In contrast, there is little difference between the portfolios formed by the trades of nonhedge fund institutions.
  • Undervalued stocks with higher hedge fund ownership and trades in one quarter are more likely to have mispricing corrected in the next quarter, suggesting that hedge funds help reduce mispricing, though price correction does not occur instantaneously.
  • For nonhedge-fund institutional investors, including banks, insurance companies and mutual funds, their stock ownership, on average, is neither related to stock underpricing nor predictive for stock returns.
  • There is a significant relation between lagged idiosyncratic volatility and hedge fund ownership (but not nonhedge-fund ownership). In contrast, there is no significant relation between the trades of nonhedge-fund institutions and idiosyncratic volatility. This finding is consistent with the view that hedge funds bear arbitrage cost when exploiting price inefficiencies.

The above findings led the authors to conclude that hedge funds play an important role in the process of security price formation and help to make the market more efficient.

Do Investors Benefit?

Let’s turn to examining if investors benefit from the alpha generated from identifying undervalued stocks.

Let’s start with the 4.8% alpha found by the authors. Let’s assume trading costs, including market impact, reduce the alpha to 4.0%. Historically, the U.S. stock market has returned about 10%. A 4% alpha would mean that hedge funds would produce a gross return of 14%.

Now let’s reduce that gross return by the typical 2/20 fee charged. Subtracting the 2% expense ratio reduces the gross return to 12%. Subtracting the incentive fee of 20% would reduce that to 9.6%.

That’s assuming there are no other manager fees, which is often not the case. In the chapter on hedge funds in my book “The Only Guide You’ll Ever Need to Alternative Investments,” co-authored with Jared Kizer, we cited a study by LJH Global Investments, a Naples, Florida, advisor to hedge fund investors, of about 100 hedge funds that found the average bill for “other” expenses was 1.95%.*1 If we subtract that amount, the net return to investors would drop to about 7.6%.

It’s easy to see why David Swenson, chief investment officer of the Yale Endowment, offered this observation: “In the hedge fund world, as in the whole of the money management industry, consistent, superior, active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure, due to the materially higher levels of fees.”2


The evidence from the study “Hedge Funds and Stock Price Formation” demonstrates both that hedge funds appear to have the ability to identify mispriced stocks, and their actions improve the price discovery function, increasing market efficiency.

However, it also shows that all the alpha is going to the hedge fund sponsor, which is exactly what economic theory posits—economic rents (excess profits) should go to the scarce resource, which is the ability to generate alpha.

If you are interested in the latest evidence on hedge fund returns, check out my ETF.com post of July 20, 2018, “Hedge Funds Still Trailing.”

  1. Anne Tergesen, “A Fee Frenzy at Hedge Funds,” Bloomberg Businessweek, June 6, 2005.
  2. David Swensen, “Unconventional Success: A Fundamental Approach to Personal Investment,” (Free Press, 2005), p. 126.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.