Read the working paper
INSEAD Working Paper 2015/12/FIN
The existing literature treats the short side (i.e., short selling) and long side of hedge fund trading (i.e., changes in holdings) independently. The two sides, however, complement each other in revealing important economic motivations of trading: opposite changes in short interest and hedge fund holdings are likely to be driven by information, whereas simultaneous increases (decreases) in short interest and hedge fund holdings may be motivated by hedging (unwinding) considerations. We use this intuition to identify informed demand, and document that it exhibits highly significant predictive power on returns: stocks with informed long demand can outperform stocks with informed short demand by approximately 10% per year. We also find that informed demand forecasts future firm fundamentals (e.g., ROA, earnings surprise, analyst revision) but that it is less related to mutual fund flows or liquidity provision. These findings suggest that information discovery about firm fundamentals could be among the most important drivers for informed demand.