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Hedge funds and sentiment-induced overpricing: Arbitrageurs or speculators?

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  • Kooli, Maher
  • Zhang, Min

Abstract

This study examines whether hedge funds act as arbitrageurs correcting sentiment-induced overpricing (SIO) or as speculators amplifying mispricing. We introduce βSIO, a novel measure capturing funds' sensitivity to SIO, and classify them into arbitrageurs (ARBs), speculators (SPEs), or neutral. Using a comprehensive sample of equity-oriented hedge funds, we find that ARBs (5 %-14 %) generate superior risk-adjusted returns by shorting overpriced securities, particularly those easier to correct. In contrast, SPEs (3 %-9 %) underperform by riding sentiment-driven trends. While ARBs enhance market efficiency, their effectiveness diminishes during speculative bubbles and financial crises due to limits to arbitrage. Portfolio strategies based on βSIOyield economically significant alphas (0.81 % monthly for top-decile ARBs versus −0.21 % for bottom-decile SPEs), indicating its value for hedge fund selection. Our results reconcile conflicting evidence on hedge funds' role in sentiment-driven markets, providing new insights into the conditions under which arbitrage strategies succeed.

Suggested Citation

  • Kooli, Maher & Zhang, Min, 2026. "Hedge funds and sentiment-induced overpricing: Arbitrageurs or speculators?," Research in International Business and Finance, Elsevier, vol. 81(C).
    • Handle: RePEc:eee:riibaf:v:81:y:2026:i:c:s0275531925004167
    DOI: 10.1016/j.ribaf.2025.103160
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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity

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