Wall Street’s hedge fund obsession vindicated in research

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Wall Street’s obsession with where the money is flowing has some fresh academic vindication.

Hedge funds exert far more power on equity prices than most other classes of investors, according to a recent paper, while the passive cohort are among the least influential.

Ralph Koijen at the University of Chicago, Robert Richmond at New York University and Motohiro Yogo at Princeton University used a decade of data across the U.S., U.K., euro area and Japan.

Their conclusion: The fast money has more than three times the impact on equity valuations, per dollar under management, than long-term investors like pension funds.

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The insights provide ammo for stock allocators who front-run the buying and selling activity of their influential peers, in a world that can famously punish those trading on the basis of fundamentals.

“The influence of hedge funds is remarkable given their relatively small size,” the authors wrote. Smaller investment advisors had the second-greatest impact on price, and proved even more influential across a host of other characteristics, Koijen et al found.

“Small, active investment advisors are most important for the pricing of payout policy, cash flows, and the fraction of sales sold abroad,” they said.

The findings are a timely reminder of the key role played by actively managed money across major markets. While passive investing has been luring assets for years and makes up an increasingly significant chunk of daily trading, there are worries it could ultimately disrupt price discovery.

The research didn’t speculate on the future. But it did note that if hedge funds were to shift to a market index strategy, that would mean bigger price moves are needed to have any impact on a large passive portfolio.

Index funds with the biggest 10-year net flows down 3% in 2020
The leaders raked in a combined $949 billion over the past decade.

The study also highlighted an implication of small, active investment advisors being so vital to how securities are price abroad.

“If these investors would hold a market-weighted strategy instead of their current strategy, the coefficient of valuation ratios on the fraction of sales that is exported would decline by more than 10%,” the trio wrote. “These investors therefore play an important role in determining the cost of capital of global firms.”

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