Matti Suominen's article was accepted to the Management Science
Article "Hedge Funds and Stock Market Efficiency" by Joni Kokkonen (Catolica) and Matti Suominen has been accepted for publication in the Management Science.
We measure misvaluation using the discounted residual income model. As shown in the literature, this measure of stocks’ misvaluation significantly explains their future cross-sectional returns. We measure the market level misvaluation (market inefficiency) by the misvaluation spread: the difference in the misvaluation of the most over- and undervalued shares. We show that the misvaluation spread is a strong predictor of a misvaluation based long-short portfolio’s returns, reinforcing the hypothesis that it proxies for the level of mispricing in the stock market. Using data on hedge fund returns, hedge fund industry AUM, flows, and individual hedge fund holdings, we present evidence that hedge funds’ trading reduces market level misvaluation. Our results are robust across different time periods and are not driven by market liquidity. Moreover, we find that mutual funds do not have a similar, price-correcting effect as hedge funds.
Paper can be downloaded at SSRN: http://ssrn.com/abstract=2133394