Abstract:

I provide novel evidence that hedge funds predict and drive the movement of asset prices towards fundamental value. Willingness to move prices, proxied by the share of trading volume consumed, reveals information: the volume consumed by quarterly hedge fund trades strongly predicts future stock returns. The top decile of purchases generates abnormal returns of 5-9% annualized during the following quarter (t-stat 4.4-6.5). Interpreting this phenomenon using the Kyle model of price impact, I test for the empirical patterns one should observe if informed (hedge fund) trades incorporate information into prices. Informed trading impounds earnings news, reducing the reaction to positive earnings announcements by 28%. Informed trading also positively predicts contemporaneous price movement and future informed trading. These price movements do not reverse. In contrast, mutual fund trades are significantly less informative. Structural and reduced-form estimates imply that consuming 1% of quarterly volume generates 0.3%-0.5% of price impact. Taken together, these results suggest that funds incorporate substantially more information into prices than is apparent from their fund-level returns.