When it's Rational to Buy Irrationally Priced Stocks
A behavioral finance study analyzes hedge fund trading during the dot-com technology bubble.
It has been axiomatic in modern market analysis that hedge funds play an important role in efficient markets by nudging misaligned and irrationally priced securities to the rational path.
But do hedge funds always counter market irrationality? Do they act as a brake on over exuberant investors? A groundbreaking study by Stefan Nagel, assistant professor of finance at Stanford GSB, finds that hedge funds not only failed to create a stabilizing force during the technology bubble of 1998-2000 but instead profitably rode the bubble by taking advantage of the very core of “irrational exuberance,” the term that Federal Reserve Board Chairman Alan Greenspan coined in a key caution of stock market excess.
Nagel and co-author Markus Brunnermeier of Princeton University conclude that hedge fund managers were amply aware of the exaggerated market response for technology stocks. “Overall,” the researchers write, “our evidence casts doubt on the presumption underlying the efficient markets hypothesis: that it is always optimal for rational speculators to attack a bubble.” The article is published in the October 2004 Journal of Finance.
The premise of counter-trading by sophisticated investors “has been the main argument for why bubbles could not happen,” Nagel said in an interview. Yet, the study’s results importantly support recent theories of the limits of arbitrage. According to these theories, rational investors reasonably refuse to short or trade against even plainly overpriced securities if they believe most investors will continue to act irrationally, such that the security’s trading price will continue to rise. These, of course, are the very conditions of a market bubble.
“There is no evidence that hedge funds as a whole exerted a correcting force on prices during the technology bubble,” Nagel and Brunnermeier write. Indeed, “among the few large hedge funds that did resist the bubble], the manager with the least exposure to technology stocks — Tiger Management — did not survive until the bubble burst.” Nagel and Brunnermeier note in the study that Tiger Management was an example of a classically rational investor. Tiger declined to take major positions in technology stocks, believing them to be overpriced. While Tiger Management was proved right in the long run, its results fell far behind other funds that soared with the “irrational” approach of buying technology issues. Tiger was compelled to close up shop.
“The key to this is that if you feel you can predict what the irrational guys are doing, then it may be entirely rational to buy irrationally priced stocks,” Nagel said. In part, these possibilities arise because of time factors in hedging. Hedge traders generally are unwilling to hold short positions for a long period. Instead of betting on long-run reversal to fundamentals, they may prefer to follow short-run trends in the behavior of “noise traders,” as economists call them. “It seems that the hedge funds did exploit such a predictability during [the bubble],” noted Nagel.
Nagel and his co-author use a novel approach with the usually secretive hedge funds to unearth trading patterns. They turn to quarterly filings with the Securities and Exchange Commission. These so-called 13F filings are required of all investment institutions with more than $100 million under discretionary management for securities positions of 10,000 shares or greater with a value more than $200,000. “It hasn’t been generally known that hedge funds filed these forms like any other institutional investor,” Nagel said.
The data provide a fascinating insight into hedge fund equity strategies during the technology bubble. The authors find that hedge funds ramped up their tech holdings in 1999, and then, with excellent timing, stepped away from long positions in the sector-holding on to big gains as the market tumbled in 2000 and later.
Not only did funds do this in the aggregate, but their timing on individual stocks was prescient as well, Nagel and his co-author say. What might we conclude from hedge fund behavior and the efficient markets hypothesis? “We have to be careful here,” Nagel cautioned. “Their behavior may be rational from the perspective of the hedge funds,” he added. Think of it perhaps as rational relativism: The hedge funds “may act in a way that does not lead to a rational [price] level — at least not right away,” the economist said.
In Nagel’s view, “the culprit is more likely to be found in the individual or unsophisticated investors; the main problem may be too many day traders — enough to allow hedge funds to predict their behavior and enough for the funds to ride the bubble.” Indeed, in terms of public policy, “it may be more important to encourage these not-so-sophisticated people to behave more rationally than to regulate hedge funds.”
Nagel and Brunnermeier’s work bolsters the emerging field of behavioral finance by looking closely at asset pricing in what some think of as psychological terms. Their findings of hedge fund behavior during the technology bubble of our lifetime has been replicated by an MIT working paper that finds similar behavior by Hoares Bank, a savvy British player during the famous South Sea Bubble of 18th-century England, in which a putative trading company offered a stock exchange for all British government debt. A bloating of stock values soon followed the South Sea Company’s offer. Importantly, there were no limits on leverage of short trades nor locked up company stock, two factors sometimes blamed for hedge fund actions in the latest technology bubble, something that confirms findings by Nagel and Brunnermeier in “Hedge Funds and the Technology Bubble.”
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