Hedge Funds and Stock Market Efficiency

Abstract

We measure misvaluation using the discounted residual income model. Confirming the findings in the literature, we show that there are significant returns on a misvaluation based long-short portfolio that buys under- and sells short overvalued shares. We define misvaluation spread as the difference in the misvaluation of over- and undervalued shares. We show that this measure is a strong predictor of the misvaluation based long-short portfolio’s returns, reinforcing our hypothesis that it proxies for the overall level of mispricing in the stock market. Our main finding is that hedge fund industry flows significantly reduce the misvaluation spread: one standard deviation increase in flows is associated on average with a 2.5% decrease in the misvaluation spread. We find that this effect comes solely from hedge funds exposure to undervalued shares: hedge fund flows reduce the undervaluation of undervalued shares, but not the overvaluation of overvalued shares.