Hedge fund holdings and stock market efficiency ? ‚ Hedge fund holdings and stock market...

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  • Hedge fund holdings and stock market efficiency

    Charles Cao Penn State University

    Bing Liang

    University of Massachusetts

    Andrew W. Lo MIT Sloan School of Management

    Lubomir Petrasek**

    Board of Governors of the Federal Reserve System

    May 2014

    ______________________________________________________ * We are grateful to Jonathan Goldberg, David Hirshleifer, Francisco Vazquez-Grande, Tom King, Kurt Lewis, An-na Orlik, Jeremy Stein, Sheridan Titman, Ashley Wang, and seminar participants at the Federal Reserve Board of Governors, Bentley University, University of Massachusetts Amherst, Texas A&M, UC Irvine, and Georgetown University for their valuable comments and suggestions. We thank George Aragon and Philip Strahan for providing their data on shareholdings of Lehman-connected hedge funds. Special thanks to Matt Eichner for extensive discus-sions of the Lehman Brothers bankruptcy proceedings. We are grateful to Edward Atkinson and Grant Farnsworth for excellent research assistance. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff of the Board of Governors, AlphaSimplex Group, or any of its affiliates and employees. Smeal College of Business, Penn State University, University Park, PA 16802; qxc2@psu.edu. Isenberg School of Management, University of Massachusetts, Amherst, MA 01003; bliang@isenberg.umass.edu. MIT Sloan School of Management, Cambridge, MA 02142; alo@mit.edu. ** Board of Governors of the Federal Reserve System; 20th Street and Constitution Avenue N.W. Washington, D.C. 20551; lubomir.petrasek@frb.gov.

  • Hedge fund holdings and stock market efficiency

    ABSTRACT We examine the relation between changes in hedge fund stock holdings and measures of in-formational efficiency of equity prices derived from transactions data, and find that, on av-erage, increased hedge fund ownership leads to significant improvements in the informa-tional efficiency of equity 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 effi-ciency 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.

    Keywords: hedge funds, institutional investors, market efficiency.

    JEL Classifications: G14, G23.

  • 1

    Hedge fund ownership of stocks has increased rapidly over the past decade, in particular pri-

    or 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-

    pricings. Indeed, academic researchers and practitioners have long regarded hedge funds as among

    the most rational arbitrageurssophisticated investors 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 sys-

    tem 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.

    This view fits with the fact that hedge funds engage extensively in investment research, conduct sta-

    tistical and event-driven arbitrage, and in many cases act as informed activist investors (e.g., Brav et

    al., 2008).

    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 elimina-

    tion of arbitrage opportunities by sophisticated investors such as hedge funds is not necessarily asso-

    1 Testimony of Alan Greenspan before the House Committee on Banking and Financial Services (October 1st, 1998).

  • 2

    ciated 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 (2007, 2011) is a clear example of a crowded trade

    that led to the kind of fire sales and liquidity spirals theorized by Stein (2009).

    In addition, many hedge funds leverage their investments, typically through short-term fund-

    ing (e.g., Lo, 2008; Ang, Gorovyy, and Inwegen, 2011). This reliance on short-term funding leaves

    their portfolios exposed to funding shocks. If hedge funds access to funding is impaired, as it was

    during the recent crisis, hedge funds could be forced to sell assets at fire sale prices. The forced sell-

    ing imposed by lenders can be associated with near-term asset value deterioration and inefficient

    pricing (e.g., Brunnermeier and Pedersen, 2009; Khandani and Lo, 2007, 2011; Teo, 2011; Mitchell

    and Pulvino, 2012). Finally, hedge funds may decrease their market exposure or even withdraw from

    markets altogether when market liquidity is low, thus increasing non-fundamental volatility during

    liquidity crises (e.g., Cao, Chen, Liang, and Lo, 2013).

    Understanding the role of hedge funds in securities markets is important for several reasons.

    First, because of hedge funds increased involvement in public equity markets, many investors hold

    stocks that are owned and traded by hedge funds. These investors are favorably (adversely) affected

    by the higher (lower) price efficiency that results from hedge fund trading. According to Pagano

    (1989), risk-averse investors may even choose to desert stocks with high volatility unrelated to fun-

    damentals. Further, hedge funds have recently come under increased regulatory scrutiny because of

    the possibility that their trading may contribute to financial crises. It is therefore of interest to regula-

    tors whether hedge fund ownership makes stock prices more informative or, instead, increases pric-

    ing errors, especially during times of market stress. Finally, hedge funds contribution to price effi-

    ciency matters because the information in stock prices guides investment decisions and therefore the

  • 3

    allocation of economic resources and welfare (Tobin, 1969; Dow and Gorton, 1997). More efficient

    stock prices also improve investor welfare by facilitating hedging and risk sharing (Dow and Rahi,

    2003).

    To test the two competing hypotheses regarding how hedge funds affect market efficiency,

    we empirically examine the relation between changes in hedge fund ownership of stocks and the in-

    formational efficiency of prices. We derive three measures of informational efficiency from stocks

    intraday trades and quotes: pricing error variance (PEV), return autocorrelations, and variance ratios.

    Our main measure (PEV) was proposed by Hasbrouck (1993), and uses statistical techniques to re-

    solve the time series of security transactions prices into a random walk component and a residual sta-

    tionary component (see Beveridge and Nelson, 1981). The random walk component is identified as

    the efficient price, and the residual component as the pricing error. PEV measures how closely actu-

    al transaction prices track a random walk. It is therefore a natural measure of price efficiency. The

    other two measures of price efficiency, return autocorrelations and variance ratios, capture patterns in

    stock returns that are inconsistent with efficient pricing, namely serial dependencies in quote mid-

    point returns and discrepancies between the variances of long-term and short-term returns.

    Using comprehensive data on quarterly changes in hedge fund equity holdings between 2000

    and 2012, we find that stocks bought by hedge funds subsequently increase in price efficiency com-

    pared with stocks sold by hedge funds in the same period. This finding supports the view that, on

    average, hedge funds operate as arbitrageurs and contribute to the informational efficiency of prices.

    However, this effect was reversed during liquidity crises, most notably in the last quarter of

    2008, when greater hedge fund ownership led to subsequent declines in price efficiency. The de-

    clines in price efficiency coincided with sharp increases in the TED spread (the diff