Research by Daniel Schmidt Accepted in the Review of Asset Pricing Studies

Associate Professor of Finance Daniel Schmidt has had his research paper “Fundamental Arbitrage under the Microscope: Evidence from Detailed Hedge Fund Transaction Data” accepted for publication in the Review of Asset Pricing Studies, one of the best journals in financial asset pricing. The research is in collaboration with Bastian von Beschwitz from the Federal Reserve Board and Sandro Lunghi from Inalytics.

Fundamental trading, or trading on information acquired through fundamental research, is important for rendering stock market prices more informative. Yet, because of a paucity of data from real-world fundamental traders, we know very little about this activity and its limits. In this paper, we conduct the first detailed study on the limits of fundamental trading by exploiting a rich proprietary transaction data set for a sample of 21 hedge funds over a 10-year period. Two features make the data unique: First, it exclusively covers discretionary long-short equity hedge funds, which routinely undertake independent long and short investments (“directional bets”), making them archetypical fundamental arbitrageurs. Second, our data comprise all their stock transactions, allowing us to exactly pinpoint the dates when they enter and close their arbitrage positions.

In our data, we find that the long-short equity hedge funds behave like informed but constrained fundamental investors. Specifically, we show that their openings of long and short positions are followed by significant four-factor alphas with an absolute magnitude of about 1% over the next 125 trading days, suggesting that these hedge funds are skilled. When measured over the holding period (i.e., from opening to close), the difference in four-factor alpha between long and short positions amounts to 2%. In stark contrast, we find that closing trades are followed by returns in the opposite direction of the closing trade. When we design a trading strategy that goes long in stocks in which hedge funds just closed a long position (long sells) and shorts stocks from closed short positions (short buys), we obtain a significant four-factor alpha of about 0.9% over the next 125 trading days. This figure implies that the hedge funds in our sample forgo about one-third of the trade's potential profitability. We thus establish that the constraints faced by long-short equity hedge funds are economically important as they force them to “leave substantial money on the table.” We argue that hedge funds close positions early to reallocate their capital to more profitable investments and/or to accommodate tightened financial constraints. Consistent with this view, we document that hedge funds leave more money on the table after opening new positions, negative returns, or increases in funding constraints and volatility.