Abstract
We document that hedge funds nurture mispricing in the Chinese financial market. We exploit the relationship between hedge fund holdings and the degree of mispricing in case that hedge fund holdings of stocks are mainly for arbitrage purpose but not for hedging, and that with and without short-selling restrictions. Hedge funds intentionally hold overvalued stocks. Their trades, which generate an abnormal return to 1.78% per month, also impede the dissipation of stock mispricing. Further, we find trend chasing may be the reason why hedge funds prefer to hold overvalued stocks. This research sheds new lights on the information content and potential investment value of hedge funds holdings in emerging markets.
Highlights
There is controversy regarding whether arbitrageurs are a stabilizing force that keeps stock prices close to fundamental values
The results show that stocks with high hedge fund holdings generate an abnormal return to 1.78% per month, resulting in a return spread of approximately 4.8% per year compared with low hedge fund holdings
We test whether hedge funds hold overvalued stocks and the relationship between hedge fund holdings and the magnitude of relative mispricing, absolute mispricing or anomaly mispricing
Summary
There is controversy regarding whether arbitrageurs are a stabilizing force that keeps stock prices close to fundamental values. Study of Chinese hedge funds would provide new evidence on the behavior of arbitrageur and contribute to the debate of whether hedge funds drive stocks prices to converge on their fundamental values. This suggests that hedge funds deliberately hold overvalued stocks Their riding on bubble behavior is not caused by market friction, which is consistent with Griffin et al (2011) and Brunnermeier and Nagel (2004). The shortselling ban lift in China allows us to study the behavior of hedge funds before and after market friction has been alleviated, which is different from Huang, Yao, and Zhu (2018) who focus on hedge fund performance and growth under short-selling restrictions in China.
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