Arbitrage involvement and security prices

We propose that hedge funds more aggressively buy underpriced stocks when they are allowed to short. To test our proposition, we utilize the institutional feature in Hong Kong in virtue of which only stocks added to a special list can be shorted. Our first-stage analysis uses hedge fund holdings data and provides evidence that the emergency of shortable securities, indeed, causes hedge funds to more aggressively buy seemingly underpriced stocks. Our second-stage analysis presents evidence that hedge funds’ increased involvement in these stocks helps correct underpricing and moves prices in the direction of fundamentals.