Would it ever be rational to buy something you know to be overpriced? Research on hedge fund trading during the dot com bubble suggests the answer is yes. Analysis of hedge fund trades on shares of inflated technology stocks shows that sophisticated investors were able to trade profitably even when the stocks were overpriced, by riding the bubble up and selling high through market timing. Stefan Nagel of the London Business School and Markus Brunnermeier of Princeton describe their research:

The premise of counter-trading by sophisticated investors “has been the main argument for why bubbles could not happen,” Nagel said in an interview. Yet, the study’s results importantly support recent theories of the limits of arbitrage. According to these theories, rational investors reasonably refuse to short or trade against even plainly overpriced securities if they believe most investors will continue to act irrationally, such that the security’s trading price will continue to rise. These, of course, are the very conditions of a market bubble.

“There is no evidence that hedge funds as a whole exerted a correcting force on prices during the technology bubble,” Nagel and Brunnermeier write. Indeed, “among the few large hedge funds that did resist the bubble], the manager with the least exposure to technology stocks—Tiger Management—did not survive until the bubble burst.” Nagel and Brunnermeier note in the study that Tiger Management was an example of a classically rational investor. Tiger declined to take major positions in technology stocks, believing them to be overpriced. While Tiger Management was proved right in the long run, its results fell far behind other funds that soared with the “irrational” approach of buying technology issues. Tiger was compelled to close up shop.

“The key to this is that if you feel you can predict what the irrational guys are doing, then it may be entirely rational to buy irrationally priced stocks,” Nagel said. In part, these possibilities arise because of time factors in hedging. Hedge traders generally are unwilling to hold short positions for a long period. Instead of betting on long-run reversal to fundamentals, they may prefer to follow short-run trends in the behavior of “noise traders,” as economists call them. “It seems that the hedge funds did exploit such a predictability during [the bubble],” noted Nagel.

The abstract in their own words:

The efficient markets hypothesis is based on the presumption that rational speculators would find it optimal to attack price bubbles and thus exert a correcting force on prices. We examine stock holdings of hedge funds during the time of the Technology Bubble on NASDAQ and find that the portfolios of these sophisticated investors were heavily tilted towards (overpriced) technology stocks. This does not seem to be the result of unawareness of the bubble: At an individual stock level, hedge funds reduced their exposure before prices collapsed, and their technology stock holdings outperformed characteristics-matched benchmarks. Our findings do not conform to the efficient markets view of rational speculation, but they are consistent with models in which rational investors can find it optimal to ride bubbles because of predictable investor sentiment and limits to arbitrage. Moreover, frictions such as short-sales constraints do not appear to be sufficient to explain why the presence of sophisticated investors failed to contain the bubble.

Read more:

• Stanford Research: Make Day Traders Act Rationally Rather Than Regulate Hedge Funds
• Hedge Funds and the Technology Bubble, by Markus Brunnermeier and Stefan Nagel