Mispricing chasing and hedge fund returns

Abstract

Various anomalies identified in the literature provide investors with enormous opportunities to chase mispriced stocks. This paper investigates hedge funds’ mispricing-chasing behaviors. We use two mispricing factors in the literature, namely Anomaly-Long and Anomaly-Short, to develop a mispricing-chasing model, through which we examine the evidence of mispricing-chasing behaviors among equity-oriented hedge funds. We find that, faced with different types of mispricing opportunity, hedge funds exploit mispricing opportunities differently, either by capturing the underlying market exposure or reaping profits via short selling. Extending the fund classification model in the literature, we classify funds into different skill groups. We find approximately one-third of the equity-oriented hedge funds are classified as excellent/good mispricing chasers. Furthermore, we evaluate the underlying determinants for funds’ grouping and find that excellent/good mispricing chasers tend to be of smaller size, to charge a higher actual annual fee, and to have been established for a shorter time. This finding not only serves as an important reference for investors when selecting profitable hedge funds, but also provides important information helping hedge funds to stay competitive in the industry. • We develop a mispricing chasing model based on anomaly-based factors. • We show evidence of mispricing chasing for hedge funds. • We extend the fund classification method and classify funds into skill groups.