Hedge Funds and Prime Broker Risk
We show that large adverse shocks to an individual prime broker only impact the performance of hedge funds using the affected broker exclusively, highlighting the diversifiability of idiosyncratic shocks. Conversely, we find systematic financial intermediary risk a significant determinant in the cross-section of hedge fund returns. Moreover, the average hedge fund's exposure to this risk exceeds the aggregate risk of its holdings. This incremental exposure is asymmetric, driven solely by negative intermediary shocks. In contrast, mutual funds and other risk factors show no similar effect. Our findings underscore the unique risks of hedge funds due to their prime brokerage dependencies.
Optimists, Pessimists and Stock Prices
We review the academic findings from psychology and economics on disagreement, and specifically on the effect of disagreement on asset prices. We discuss measurement of disagreement, and how disagreement coupled with constraints on short selling can sideline pessimistic investors and result in overpricing. We review the literature on the short-selling in financial markets, paying particular attention to how and why some issues become "hard-to-borrow", what factors go into the determination of borrowing-costs, and discuss the evolution of borrow costs over the last several decades. We show how an examination of the prices and borrow costs for constrained stocks can lead to an improved understanding of how disagreement in financial markets arises and is resolved, and finally discuss directions for future research.
Streaks in Daily Returns
Streaks in returns, which we define as n-day consecutive over-/under-performance relative to the market, predict future daily returns. A value-weighted portfolio buying stocks with negative streaks and selling stocks with positive streaks yields annualized Sharpe ratios around 1.8 in the U.S. (1998--2022). We replicate the result in international equity markets and find low correlations across regions. Predictability is robust among the largest (market capitalization above the 50\% or 80\% NYSE quantiles) and most liquid stocks (e.g., low bid-ask spread or Amihud measure tercile). A model of short-term return extrapolation among investors generates predictions consistent with the empirical findings.
The Dynamics of Disagreement
In this paper, we infer how the estimates of firm value by "optimists" and "pessimists" evolve in response to information shocks. Specifically, we examine returns and disagreement measures for portfolios of short-sale-constrained stocks that have experienced large gains or large losses. Our analysis suggests the presence of two groups, one of which overreacts to new information and remains biased over about 5 years, and a second group, which underreacts and whose expectations are unbiased after about 1 year. Our results have implications for the belief dynamics that underlie the momentum and long-term reversal effect.