Informed Trading by Hedge Funds

Using daily equity transactions, we create a hedge fund informed trading measure (ITM) that separates information related trades from liquidity driven trades. We find that stocks with higher hedge fund informed trading are associated with higher future stock performance. The long-short portfolio delivers 4% annual alpha after controlling for size, value, momentum, and illiquidity factors. The results are mainly driven by the long side of informed trading. We attribute the informed trading to funds' ability to identify and correct stock underpricing. The results are robust to various ways of constructing and sorting the measure, and we do not find a return reversal in 4 quarters, indicating that the measure is information related