The Role of Hedge Funds in the Security Price Formation Process Charles Cao Yong Chen Will Goetzmann Bing Liang
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1 The Role of Hedge Funds in he Securiy Price Formaion Process Charles Cao Yong Chen Will Goezmann Bing Liang European Financial Managemen Associaion Aunnual Meeings, 2014
2 Asses ($MM) Toal Hedge Fund Asses Under Managemen ( ) $3,000,000 $2,750,000 $2,628,329 $2,500,000 $2,250,000 $2,252,378 $2,000,000 $1,868,419 $1,917,385 $2,008,065 $1,750,000 $1,600,156 $1,500,000 $1,464,526 $1,407,095 $1,250,000 $1,105,385 $1,000,000 $972,608 $820,009 $750,000 $500,000 $367,560 $490,580 $456,430 $374,770 $625,554 $539,060 $250,000 $0 $38,910 $58,370 $8,463 $256,720 $185,750 $167,790 $95,720 $167,360 $27,861 $36,918 $14,698 $57,407 ($1,141) $91,431 $4,406 $55,340 $23,336 $46,545 $99,436 $70,635 $73,585 $46,907 $194,515 $126,474 $55,464 $70,596 $34,433 $63,747 ($250,000) ($131,180) ($154,447) ($500,000) Esimaed Asses Ne Asse Flow
3 Do They Desabilize he Marke? Asian currency crisis: Brown e al. (1999): No profis for major funds Tech bubble: Brunnermeier and Nagel (2004) Griffin and Xu (2009) Boh conclude HFs exacerbaed bubble or does no add value Acivis: Brav e al. (2008), Bech, Frank and Gran (2008), Miezner and Schwiezer (2008) HFs profi and oher invesors benefi
4 Lehman Crisis Liquidiy Aragon and Srahan (2009): Lehman effecs linked o prime brokers. Algorihmic Trading Hendersho e al. (2011): Algo rading improves liquidiy. On Average Jynlha e al. (2012 ): Use he facor approach o deec liquidiy provision. HFs Mosly Are Suppliers of Liquidiy
5 Wha Do We no ye Know abou Hedge Funds and he Markes? Do hey exploi mispricing? Do hey make prices more efficien?
6 Daa Hedge fund daa: TASS, HFR, CISDM, Barclay Hedge, and Morningsar Online sources and Form ADV 1,356 hedge fund companies, among which 1,053 (5,071 funds) are from he five daabases and 303 are from oher sources Equiy holding daa: CDA/Specrum 13F Equiy daa: CRSP and COMPUSTAT
7 Table 2: Summary Saisics of Sock Characerisics Variable (All) Mean Sd. Dev. Median 25% 75% Book/Marke Marke cap ($bil) Dividend yield (%) Age (monh) Price ($) SP500 dummy Variable (op HF) Mean Sd. Dev. Median 25% 75% Book/Marke Marke cap ($bil) Dividend yield (%) Age (monh) Price ($) SP500 dummy
8 Table 3: Lagged Alpha and Insiuional Ownership for Posiive Alpha Socks (1) (2) (1) (2) VARIABLES IO_HF IO_Non_HF p-value of difference Alpha *** (6.09) (-0.91) 0.00 Ln(Book/Marke) *** 0.106*** (4.33) (9.94) 0.00 Ln(Marke Cap) *** 0.532*** (11.15) (28.00) 0.00 Ln(Dividend yield) *** *** (-12.50) (-15.10) 0.00 Ln(Age) *** 0.041*** (-4.40) (4.27) 0.00 Ln(Price) *** 0.110*** (-3.56) (7.02) 0.00 SP500 dummy *** *** (-5.87) (-4.04) 0.14 Consan *** 0.109*** (-4.03) (4.46) R-squared
9 Idiosyncraic Risk The price efficiency inerpreaion: The marke is efficien and already incorporaes firm-specific informaion, socks wih high idiosyncraic risk are riskier o hedge so hedge funds will avoid hese socks. In he Grinold and Kahn (1999) world, idiosyncraic risk reduces he informaion raio The price inefficiency inerpreaion: High idiosyncraic risk socks represen for inefficiencies o invesmen opporuniies
10 Table 4: Lagged Idiosyncraic Risk and Insiuional Ownership for Posiive Alpha Socks (1) (2) (1) (2) VARIABLES IO_HF IO_Non_HF p-value of difference Idio. risk *** (6.28) (-0.01) 0.00 Ln(Book/Marke) *** 0.108*** (4.53) (10.35) 0.00 Ln(Marke Cap) *** 0.534*** (11.26) (28.50) 0.00 Ln(Dividend yield) *** *** (-11.47) (-15.03) 0.00 Ln(Age) *** 0.042*** (-4.32) (4.45) 0.00 Ln(Price) *** 0.112*** (-2.62) (6.85) 0.00 SP500 dummy *** *** (-5.87) (-4.03) 0.14 Consan 0.086*** 0.092*** (5.90) (5.76) R-squared
11 Table 5: Lagged Alpha and he Changes in Insiuional Ownership (1) (2) (1) (2) VARIABLES ΔIO_HF ΔIO_Non_HF p-value of difference Alpha ** (2.44) (0.31) 0.08 Ln(Book/Marke) (0.26) (-1.61) 0.12 Ln(Marke Cap) (0.47) (0.27) 0.91 Ln(Dividend yield) (0.58) (-1.27) 0.17 Ln(Age) *** (0.62) (-7.13) 0.00 Ln(Price) *** (-0.86) (-4.48) 0.00 SP500 dummy (-0.78) (-0.08) 0.64 Consan ** 0.111*** (-2.04) (2.97) R-squared
12 Table 6: Lagged Idiosyncraic Risk and he Changes in Insiuional Ownership (1) (2) (1) (2) VARIABLES ΔIO_HF ΔIO_Non_HF p-value of difference Idio. risk ** (2.17) (-0.23) 0.03 Ln(Book/Marke) * (0.28) (-1.91) 0.06 Ln(Marke Cap) (0.36) (0.21) 0.74 Ln(Dividend yield) (0.61) (-1.59) 0.06 Ln(Age) *** (0.70) (-7.03) 0.00 Ln(Price) *** (-0.55) (-4.67) 0.00 SP500 dummy (-0.86) (-0.08) 0.64 Consan *** (1.40) (7.94) R-squared
13 Does Hedge Fund Trading Reduce Mispricing?
14 Table 7: Insiuional Ownership and Changes in Alpha VARIABLES ΔAlpha ΔAlpha IO_HF *** (-4.44) IO_Non_HF (1.36) ΔIO_HF *** (-4.80) ΔIO_Non_HF * (-1.81) Ln(Book/Marke) *** 0.194*** (13.88) (14.23) Ln(Marke Cap) (-0.39) (0.19) Ln(Dividend yield) *** 0.117*** (10.87) (12.12) Ln(Age) (-0.25) (-0.12) Ln(Price) *** 0.292*** (20.34) (20.28) SP500 dummy (0.56) (-0.06) Consan *** *** (-71.24) (-70.25) R-squared
15 Table 8: Insiuional Ownership and Changes in Idiosyncraic Risk VARIABLES ΔIdioRisk ΔIdioRisk IO_HF *** (-3.02) IO_Non_HF *** (3.53) ΔIO_HF *** (-3.32) ΔIO_Non_HF ** (2.19) Ln(Book/Marke) (-0.39) (-0.40) Ln(Marke Cap) *** *** (-6.83) (-6.19) Ln(Dividend yield) (-0.33) (0.03) Ln(Age) *** ** (-3.27) (-2.57) Ln(Price) *** 0.134*** (9.97) (9.84) SP500 dummy (0.51) (0.59) Consan 0.032* 0.031* (1.95) (1.92) R-squared
16 Hedge Fund Ownership and Sock Reurn Predicabiliy Use he full sample of socks, ', 1,, 2, 1 1, 2 1, 1, i i i i i i m i X d HF Non IO c HF IO c HF Non IO b HF IO b a r
17 Table 9: Predicing Sock Reurns Based on Insiuional Ownership (1) (2) (3) (4) VARIABLES Re +1 Re +1 Re +2 Re +2 IO_HF (0.56) (0.28) IO_Non_HF (0.61) (1.15) ΔIO_HF 0.009*** (3.31) (0.98) ΔIO_Non_HF (0.18) (1.32) Ln(Book/Marke) * 0.019** 0.024*** 0.026*** (1.80) (2.02) (2.68) (2.92) Ln(Marke Cap) * * (-1.70) (-1.42) (-1.78) (-1.12) Ln(Dividend yield) ** 0.019** (2.27) (2.04) (1.59) (1.51) Ln(Age) *** 0.016*** 0.018*** 0.019*** (3.09) (3.02) (3.51) (3.69) Ln(Price) (1.42) (1.45) (1.24) (1.53) SP500 dummy (0.15) (0.17) (0.40) (0.34) Consan (0.37) (0.48) (1.20) (1.43) R-squared
18 VARIABLES Re +1 Re +1 Re +2 Re +2 IO_HF (-0.41) (-0.29) IO_Non_HF (0.33) (0.72) ΔIO_HF 0.007*** (2.68) (0.02) ΔIO_Non_HF *** (-3.44) (-0.77) Re *** 0.036*** 0.034*** 0.035*** (4.31) (4.52) (4.11) (4.12) Re *** 0.036*** 0.028*** 0.029*** (4.33) (4.31) (3.64) (3.61) Re *** 0.027*** (4.04) (4.09) (-1.20) (-1.34) Re *** *** (-1.17) (-1.03) (-2.88) (-2.69) Ln(Book/Marke) *** 0.028*** 0.024*** 0.025*** (3.33) (3.55) (3.10) (3.31) Ln(Marke Cap) ** * ** * (-2.03) (-1.88) (-2.44) (-1.85) Ln(Dividend yield) * 0.015* (1.88) (1.80) (1.08) (1.17) Ln(Age) *** 0.013*** 0.015*** 0.015*** (2.73) (2.69) (3.16) (3.22) Ln(Price) * 0.019** (1.51) (1.54) (1.87) (2.14) SP500 dummy (0.15) (0.30) (0.28) (0.28) Consan 0.003* 0.003* 0.004*** 0.005*** (1.76) (1.84) (2.68) (2.97) R-squared
19 Conclusion Using facor-models o idenify invesmen opporuniies, hedge funds end o hold under-valued securiies while oher insiuional invesors do no The larger he hedge fund holdings on securiies, he larger he reducion in mispricing in he following quarer; his is also rue for idiosyncraic risk An increase in he hedge fund ownership in socks predics posiive fuure sock reurns up o one quarer In sum, hedge funds play a posiive role in securiy price forming process and improve marke efficiency
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