The Role of Hedge Funds in Security Price Formation Process

This discussion presents direct evidence on the role of hedge funds in the price formation process of security prices by using a hand-collect data of hedge fund ownership. Among undervalued stocks, hedge funds on average tend to hold stocks with larger mispricing and higher idiosyncratic risk in the cross-section. The change in hedge fund holdings is informative about future stock returns over the horizon of up to two quarters. Finally, hedge fund ownership is significantly related to a reduction in stock’s under-valuation. Overall, these findings suggest that, in comparison to other types of institutions, hedge funds play a positive and unique role in stock price formation process in holding under-valued stocks and subsequently reducing mispricing in the equity markets.