Limits of Arbitrage under the Microscope: Evidence from Detailed Hedge Fund Transaction Data

We exploit detailed transaction and position data for a sample of long-short equity hedge funds to document new facts about the trading activity of sophisticated investors. We find that the initiation of both long and short positions is associated with significant abnormal returns, suggesting that the hedge funds in our sample possess investment skill. In contrast, the closing of long and short positions is followed by return continuation, implying that hedge funds close their positions too early and “leave money on the table.” As we demonstrate with a simple model, this behaviour can be explained by hedge funds being (risk) capital constrained and facing position monitoring costs. Consistent with our model, we document that the return continuation following closing orders is more pronounced when these constraints become more binding (e.g., after negative fund returns or increases in volatility).