The Role of Hedge Funds in the Security Price Formation Process
Using a comprehensive dataset of equity holdings by hedge funds, we examine whether and how hedge funds exploit and help correct mispricing. We show that hedge funds tend to hold undervalued stocks. In the cross section of undervalued stocks, both hedge fund ownership and their trades are positively related to the degree of mispricing and idiosyncratic volatility. Further, a portfolio of undervalued stocks with high hedge fund ownership generates an abnormal return of 0.48% per month. Hedge fund ownership and trades also precede dissipation of stock mispricing. By contrast, all these patterns are either nonexistent or much weaker for non hedge funds.