Abstract

We examine the relation between changes in hedge fund equity holdings and measures of informational efficiency of stock prices derived from transactions data, and find that, on average, increased hedge fund ownership leads to significant improvements in the informational efficiency of stock prices. The contribution of hedge funds to price efficiency is greater than the contributions of other types of institutional investors, such as mutual funds or banks. However, stocks held by hedge funds experienced extreme declines in price efficiency during liquidity crises, most notably in the last quarter of 2008, and the declines were most severe in stocks held by hedge funds connected to Lehman Brothers and hedge funds using leverage.

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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 owner- ship on the informational efficiency of stock prices.

An increase in hedge fund stock ownership might improve or reduce stock market efficiency. On the one hand, hedge funds could make stock prices more informationally efficient by conducting research about the fundamental value of stocks and using short-term trading strategies to exploit mis- pricing. Indeed, academic researchers and practitioners have long regarded hedge funds as among the most rational arbitrageurs—sophisticated investors who quickly respond when prices deviate from fundamental values. For example, Alan Greenspan, the former chairman of the Federal Reserve Sys- tem, 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 investors. Compared to the managers of mutual funds and other investment companies, hedge fund managers 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…