Hedge Fund Holdings And Stock Market Efficiency
Pennsylvania State University
University of Massachusetts Amherst – Department of Finance
Warren Buffett: If You Own A Good Business, Keep It
Andrew W. Lo
Massachusetts Institute of Technology (MIT) – Sloan School of Management; National Bureau of Economic Research (NBER)
Federal Reserve Board
We examine the relation between changes in hedge fund equity holdings and measures of informational efficiency of stock prices derived from intraday transactions as well as daily data. On average, hedge fund ownership of stocks leads to greater improvements in price efficiency than mutual fund or bank ownership. However, stocks held by hedge funds experienced extreme declines in price efficiency during liquidity crises, most no-tably in the last quarter of 2008, and the declines were more severe in stocks held by hedge funds connected to Lehman Brothers as a prime broker and hedge funds using leverage.
Hedge Fund Holdings And Stock Market Efficiency – Introduction
Hedge fund ownership of stocks has increased rapidly over the past decade, in particular prior to the outbreak of the Financial Crisis in 2008. At the end of 2007, hedge funds held about 10% of outstanding shares of the average firm listed on U.S. stock exchanges. Moreover, hedge fund trading accounts for at least one-third of the equity trading volume on NYSE according to the McKinsey Global Institute (2007). Hedge funds dominate the trading of certain stocks and are among the most important players in equity markets. Still, very little is known about the effects of hedge fund ownership on the informational efficiency of stock prices.
Boehmer and Kelly (2009) show that institutional investors as a whole increase the informational efficiency of transaction prices of the stocks they hold because they are more sophisticated than individual investors. It is important to note that hedge funds differ from other institutional investors in their trading styles, incentives, and use of leverage. We analyze the role of different types of institutional investors, and find that, on average, hedge funds contribute more to stock market efficiency than other institutional investors such as mutual funds or banks. Our findings also indicate that this positive role of hedge funds critically depends on the availability of funding. Using liquidity crisis events as natural experiments, we document that stocks held by hedge funds that were subject to funding shocks experienced greater mispricing during several crisis episodes.
Academic researchers and practitioners have long regarded hedge funds as among the most sophisticated investors—rational arbitrageurs who quickly respond when prices deviate from fundamental values. For example, Alan Greenspan, the former chairman of the Federal Reserve System, remarked that “many of the things which [hedge funds] do … tend to refine the pricing system in the United States and elsewhere.”1 According to Brunnermeier and Nagel (2004), hedge funds are probably closer to the ideal of “rational arbitrageurs” than any other class of institutional or individual investors. Compared to the managers of mutual funds and other investment companies, hedge fund managers are lightly regulated and have contracts that provide them with stronger incentives and a higher degree of managerial discretion (e.g., Agarwal, Daniel, and Naik, 2009), allowing hedge fund managers to spot mispricing quickly and trade with greater flexibility.
This view fits with the fact that hedge funds engage extensively in investment research, conduct statistical and event-driven arbitrage, and in many cases act as informed activist investors (e.g., Brav, Jiang, Partnoy, and Thomas, 2008). Recently, Agarwal, Jiang, Tang, and Yang (2013) find that confidential 13F filings by hedge funds can predict future stocks returns up to 12 months, and Sias, Turtle, and Zykaj (2015) show that hedge funds’ demand shocks are positively related to subsequent returns, supporting the view that hedge funds are informed traders. Akbas, Armstrong, Sorescu, and Subrahmanyam (2015) and Kokkonen and Suominen (2015) find that aggregate flows to hedge funds attenuate stock return anomalies, while aggregate flows to mutual funds exacerbate anomalies. Therefore, it is necessary to distinguish the effect of hedge funds on price efficiency from that of other institutional investors such as mutual funds or banks.
On the other hand, hedge funds’ quantitative trading strategies and reliance on leverage could destabilize financial markets and reduce price efficiency. Hedge funds often employ quantitative models to identify stocks that are undervalued or overvalued. Stein (2009) argues that the elimination of arbitrage opportunities by sophisticated investors such as hedge funds is not necessarily associated with a reduction in non-fundamental volatility. If a large number of leveraged arbitrageurs adopt the same strategy, such as buying technology stocks or the stocks of firms with low values of accruals, the resulting overcrowding could create a fire sale effect in prices, inflicting losses on other traders, and generating increases in non-fundamental volatility. In fact, the “Quant Meltdown” of August 2007 documented by Khandani and Lo (2011) is a clear example of a crowded trade that led to the kind of fire sales and liquidity spirals theorized by Stein (2009).
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