Arbitrage at its Limits: Hedge Funds and the Technology Bubble

Brunnermeier, M K and Nagel, S (2002) Arbitrage at its Limits: Hedge Funds and the Technology Bubble. Working Paper. London Business School Centre for Hedge Fund Research and Education Working Paper.

Abstract

Classical fice theory maintains that rational arbitrageurs would find it optimal to attack price bubbles and thus exert a correcting force on prices. We examine stock holdings of hedge funds during the time of the technology bubble on the NASDAQ and find that they did not attack the bubble before 2000. For those hedge fund managers who chose to ride the bubble, the timing game paid off well: stocks in the most overpriced segment of the NASDAQ held by hedge funds outperformed their characteristicsmatched benchmarks during quarters of rising prices and also when the bubble subsequently collapsed. This indicates that hedge fund managers had some success in predicting investor sentiment. Our findings are consistent with models in which arbitrage is limited, because arbitrageurs face constraints, are unable to temporally coordinate their strategies, and investor sentiment is predictable.