Rational Exuberance: Hedge fund trading strategy in bubbles
Abstract: This paper examines hedge fund trading strategy in seven bubbles and concludes that hedge funds apply different strategies for different bubbles. We analyze hedge funds' long positions in bubble stocks. Further, we run a regression to account for any short positions. We conclude that, in some bubbles, hedge funds acted in accordance with the efficient market hypothesis by helping bring overvalued stocks back to their fundamentals. However, in other bubbles, hedge funds invested a larger proportion of their portfolio in bubble stocks than the weight the stocks held in the market portfolio, implying that hedge funds were riding these bubbles. This is coherent with studies finding that rational arbitrageurs can benefit from investing in mispriced securities due to limitations to arbitrage. Using a stock-by-stock analysis, we find some evidence that hedge funds anticipated stocks' price peaks and started decreasing their positions before the bubbles burst. However, this trading strategy is not consistent for all bubbles. We contribute to previous research on hedge fund trading strategy by delimiting our scope to solely investigate general trading strategy of hedge funds in bubbles.
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