Hedge funds not doing enough to fix mispricings, study finds

Passive investing has blunted market efficiency, but hedge funds are failing to capitalise

Hedge fund managers like to say they keep markets honest by shorting overvalued assets and buying those that look cheap. In reality, though, many seem to have adopted an “if you can’t beat them, join them” strategy that may be contributing to greater volatility in financial markets.

A recent study from academics at UCLA and the University of Minnesota suggests hedge funds are failing to play the stabilising role in markets they say they do, and may even be adding to the effects of passive investing in stock markets.

“There hasn’t been much compensation for the rise of passive investing and the market has become less efficient than it was,” says Valentin Haddad, assistant professor of finance at UCLA and one of the study’s authors.

The academics used regulatory filings from 2000 to 2016 to track the way investment managers traded certain stocks that were widely held by passive investors. The study looked at investors in general, rather than hedge funds specifically. But hedge funds are generally expected to step in when other market players step back.

In an efficient market, they should have become more reactive to price changes as others became less so. In practice, firms changed their behaviour only half as much as they should have. “The stock market is far from the competitive ideal,” the academics conclude in a working paper detailing their research.

According to the study, US stock-level elasticity – the degree to which investors respond to price changes – has decreased by 35% over the past 20 years. That means selling 1% of a stock will generally cause the price to drop by 3%, Haddad says. 

This is partly due to the growth of passive strategies, which now account for nearly half the assets under management in US equity funds. The rise of passive investing – and the weak response from active investors – has reduced US stock market elasticity by 15% since 2000, the academics calculate. The study also found that some active investors have become less responsive to price changes over this time.

“Developments in computing power and access to big data would have… suggested that the most aggressive quantitative funds would have increased their elasticities,” the academics write in the paper. In fact, the elasticity of these firms fell by about 20% over the period of the study.

The findings may explain why asset prices have veered widely from fundamental value without hedge funds or others reining them back, and why investing flows affect prices disproportionately, even when conventional finance theory says they shouldn’t.

The ability of retail investors to drive up the price of meme stocks such as GameStop and AMC is one example of this type of shift in market dynamics.  

The good news for hedge funds is that, in this type of market, “there are more good deals out there to go after”, says Haddad. The downside is that “inelastic” markets, where investors are less responsive to price changes, also tend to be more fragile and prone to extreme valuations.

Passing up opportunities

If prices are not reacting quickly enough to new information, that should create more arbitrage opportunities for hedge funds and other sophisticated investors, says Ronnie Shah, head of equity research at the US quant investment firm Fort LP.  But hedge funds are limited in the risk they can take and cannot exploit every mispricing, he says. “Situations in which we’re seeing limits to arbitrage are playing out.” 

Hedge funds betting that GameStop stock was overpriced came unstuck in January when retail investors triggered a short squeeze and forced firms such as Melvin Capital out of bearish positions with billions of dollars in losses.

“If you assume there are greater opportunities now for active investors due to prices being less elastic, that should attract sophisticated investors to enter the market and take advantage,” Shah says. “But due to risk considerations, the uptake from active investors to arbitrage these anomalies could be quite slow.”

Matthew Beddall

Matthew Beddall, chief executive at investment manager Havelock London, says most hedge funds are “price reactive”, but not necessarily in a way that counteracts index funds.

“Few are willing or able to take a long-term view on valuations and hold positions until prices revert to fundamentals, which could take years,” he says. “And that cohort is shrinking.”

Growing inelasticity may also discourage hedge funds from trading more aggressively, says Michael Green, a portfolio manager at Simplify Asset Management. “If there is a relationship between returns and the inelastic price response – and there is, because rising prices raise returns – there is perversely a negative impact of trading more aggressively,” he says. Hedge funds won’t try to time the market if flows into passive strategies are resulting in rising valuations.

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• Quant investing