Hedge funds and the technology bubble

Brunnermeier & Nagel

Findings

Hedge funds did not exert a correcting force on stock prices during the tech bubble
INSTEAD HFs heavily invested in tech stocks
HFs were aware of the bubble: captured + and largely avoided by selling stock which were about to decline
Questionable whether rational speculators always stabilize prices (efficient markets notion)
Rational investors may prefer to ride bubbles, because of predictable investor sentiment and limits to arbitrage!

Introduction
1998-2000: Technology bubble

Extreme valuations: at the peak the internet sector was priced as if the average future earnings growth rate
across all these firms would exceed the growth rates experienced by some of the fastest growing individual
firms in the past and the required return would be 0 for the next few decades
Stock price increase was driven by irrational euphoria among individual investors, fed by media
Two opposing views about whether rational traders correct the price impact of behavioural traders:
o Efficient market hypothesis: rational speculative activity would eliminate riskless arbitrage
opportunities and other forms of mispricing which may require imperfectly hedged and thus risky
trades (tech bubble no close substitute for hedging)
o Factors such as noise trader risk, agency problems, synchronization risk may constrain arbitrageurs
and allow mispricing to persist Rational investors may ride bubbles for a while before attacking,
thus their actions are rather destabilizing rather than stabilizing!

Paper: examines response of HFs to the growth of the tech bubble were they a correcting force??
Findings
o HFs were riding the tech bubble
o HFs anticipated price peaks of individual tech stocks: they cut holdings before prices collapsed,
turning to stocks with increasing prices HFs captured + and largely avoided Outperformed
HFs were able to predict some of investor sentiment behind the tech bubble
The tech exposure of HFs cannot be solely explained by unawareness of the bubble
o Sophisticated investors were riding the bubble and profited: limits to arbitrage
Rational investors may be reluctant to trade against mispricing, risk aversion resulting from:
Fundamental risk: if close substitutes are unavailable
Synchronization risk: each trader is uncertain about when other trades will sell out
Noise trader risk (short horizons): possibility of temporary deepening of mispricing
Still trades would be stabilizing: sophisticated traders would still want to short assets they
know are overpriced
BUT sometimes it is profitable to invest in overpriced securities. Since a price bubble
is growing unless enough arbitrageurs attack, when not enough arbitrageurs are
likely to trade against the bubble it is optimal to ride the bubble for a while.
o The incentive to ride the bubble stems from predictable sentiment
Rational investors are able to reap gains from riding a bubble at
the expense of less sophisticated investors
o Results cast doubt on EMH that it is always optimal for rational speculators to attack a bubble:
NO evidence that HFs exerted a correcting force on prices during the tech bubble
Aversion to arbitrage risk and frictions alone are not sufficient to understand the failure of
rational speculative activity to contain the bubble

Data and sample characteristics

Focus on stocks that were most likely overvalued during the bubble (high P/S ratio)
Data used which allowed to track positions in individual stocks at quarterly basis: NO selection biases
o Info on long positions, NOT short positions & derivatives
Period of investigation: 1998-2000
Summary statistics
o Distribution of stock holdings across managers
Compared with MFs the mean holding is small
Median is lower Distribution is skewed: a few large managers account for most stock
holdings (5 largest hold 60% in first quarter of 1998)
o HF holdings are fairly concentrated typical for active managers who make deliberate bets on a
relatively small group of stock/single segment of the market
o Portfolio turnover (trading unrelated to in- or outflows) is higher than for the average MF, but still a
substantial part survives from one quarter to the next there is some low-frequency component in
HFs strategies captured by quarterly holdings

Did HFs trade against the bubble?

Attacking a bubble = selling holdings in the segment / going short.
EMH view: rational investors should short assets they know to be overpriced
AB model: rational investors may want to ride bubbles for a while

Exposure to tech stocks: portfolio weights

o HFs generally overweighted tech stocks in their portfolios
o From overweighted exposure in late 1998 HFs subsequently reduced exposure HFs were calling
the bursting of the internet bubble BUT bubble did not yet burst Increased weight in tech stocks!
This increase occurred just before the final price run-up of tech stocks
o Analysis of long positions suggests that HFs did not engage in a attack on the tech bubble, until
late 1999 their trading supported the bubble (HFs rode the bubble)
Short positions can offset not only technology exposure AND market exposure
o Accounting for short positions strengthens rather than weakens our findings that HFs had strong
long exposure to tech stocks. Short positions were used by HFs mainly to offset market exposure.
Market betas are fairly constant over time, but HFs overweighted tech stocks during almost the entire
sample period with peaks in early 2000.
o Shorts selling specialists: after mid1999 started shorting tech stocks. Still did not attack bubble.
Portfolio holdings of individual managers and fund flows
o Different managers may have taken different approaches in dealing with the bubble
o Limits to arbitrage: investors would withdraw capital from portfolio managers that lose money, even
if these losses are simply the result of a temporary deepening of mispricing

Did HFs time their exposure in individual stocks?

Did HFs rode the bubble on purpose, or were they unaware of the bubble?

HF holdings around stock price peaks

o For high P/S stocks HFs owned a greater proportion of outstanding equity BEFORE than AFTER the
price peak
o HFs seem more successful in timing their investments within the high P/S segment than within other
market segments
o HFs had some success in exiting before prices collapsed!
o HF managers let other investors bear a greater share of price collapses than of the price run-up
before the peak

HFs holdings were concentrated in tech stocks that did not really crash yet
HF tech stock picks performed much better than those of the average investors HF managers understood
that tech stocks were overvalued and that prices would come down eventually They traded accordingly
Price bubbles present particularly good profit opportunities to rational speculators, if the sentiment of
unsophisticated investors supporting the bubble is predictable to some extent HENCE riding a bubble can
be a rational strategy!

Conclusions

HFs were riding the bubble, not attacking it

o Heavily invested in tech stocks
o Short-sale constraints and arbitrage risks alone can rationalize reluctance to take short positions, but
do not explain why sophisticated investors would buy into the overpriced tech sector
HFs reduced their holdings before prices collapsed
o HFs outperformed in tech stocks HF managers understood that prices of these stocks would
eventually deflate
o Investors sentiment driving the tech bubble was predictable to some extent HFs exploited this!
o Under these circumstances riding a bubble a while can be the optimal strategy for rational investors