Swedroe: Hedge Funds & Undervalued Stocks

October 10, 2018

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.

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