Fundamental Arbitrage under the Microscope: Evidence from Detailed Hedge Fund Transaction Data

Lunghi, Sandro; Schmidt, Daniel; von Beschwitz, Bastian

doi:10.17016/FEDS.2021.022

Working Paper

Fundamental Arbitrage under the Microscope: Evidence from Detailed Hedge Fund Transaction Data

Abstract: We exploit detailed transaction and position data for a sample of long-short equity hedge funds to study the trading activity of fundamental investors. We find that hedge funds exhibit skill in opening positions, but that they close their positions too early, thereby forgoing about a third of the tradesâ€™ potential profitability. We explain this behavior with the limits of arbitrage: hedge funds close positions early in order to reallocate their capital to more profitable investments and/or to accommodate tightened financial constraints. Consistent with this view, we document that hedge funds leave more money on the table after opening new positions, negative returns, or increases in funding constraints and volatility.

Keywords: Hedge funds; Short selling; Profitability; Fundamental Trading; Limits of arbitrage;

JEL Classification: G11; G12; G14; G15;

https://doi.org/10.17016/FEDS.2021.022