Connected stocks (i.e., stocks that are held by a similar set of mutual funds) tend to co-vary more than what market dynamics would dictate. This tendency leads to potentially exploitable price changes among connected stocks that do not appear to be captured by hedge funds.
The authors examine stocks that are connected by having similar mutual fund ownership. This connectedness makes the two given stocks co-vary in a manner inconsistent with market dynamics. Consequently, this covariance can lead to stocks being mispriced and create potential trading opportunities or “contagion” within the market.
The authors find that connectedness does have an economically significant impact after they control for a number of factors. To further test the result, they examine the effect of a mutual fund scandal that took place in September 2003 (25 fund families settled allegations of illegal trading that led to significant fund outflows through 2006). The scandal was considered an exogenous event that allowed the authors to determine that connectedness could not be explained by funds simply holding similar stocks.
Given these results, the authors consider a connected-stock trading strategy in which they buy (sell) stocks that have gone down (up) if their connected stocks have gone down (up) as well. The strategy produces 9% annual abnormal returns. When comparing the trading strategy with hedge fund performance, hedge fund trading activity tends to exacerbate the price changes caused by the connectedness.
How Is This Research Useful to Practitioners?
Connectedness appears to create price changes that may or may not be exploitable. The effects of connectedness are most significant when there is a lot of mutual fund trading activity in stocks that have a low float. Consequently, liquidity may be an issue when trying to exploit price changes associated with connectedness. But if exploitable, the effects appear to last approximately six months.
How Did the Authors Conduct This Research?
The authors examine large NYSE, AMEX, and NASDAQ stocks between 1980 and 2008. Connectedness is measured at the end of each quarter as the total value of two stocks held by F common mutual funds divided by the total market capitalization of the two stocks. This measure and other control variables are used to predict the next month’s correlation between the two stocks in a cross-sectional regression. To determine that the results are not driven by mutual funds holding the same stocks, additional control variables are created to capture the effects of the mutual fund scandal in September 2003. Additional regression analysis examines the effect of float on the previous results.
The authors develop the trading strategy using the connectedness measure from the previous analysis. Two hedge fund indexes are compared with the trading strategy to determine whether hedge funds exploit connectedness. They find that hedge funds tend to exacerbate the price changes attributed to connectedness.
The analysis is interesting, particularly the finding that hedge funds do not tend to capture the price changes caused by connectedness. As stated by the authors, this finding should be examined further. Given the authors’ results when examining float, I am curious about how much of the “connectedness effect” could be attributable to liquidity.