Connected Stocks

By connecting stocks through common active mutual fund ownership, we forecast cross-sectional variation in return covariance, controlling for similarity in style (industry, size, value, and momentum), the extent of common analyst coverage, and other pair characteristics. We argue this covariance is due to contagion based on return decomposition evidence, cross-sectional heterogeneity in the extent of the effect, and the magnitude of average abnormal returns to a cross-stock reversal trading strategy exploiting information in these connections. We show that the typical long/short hedge fund covaries negatively with this strategy suggesting that hedge funds may potentially exacerbate the price dislocation we document.

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