Non-Public Information and the Trading Activity of Hedge Funds

Informed trading reduces liquidity but speeds price discovery. I compare trading by shareholder activists with trading by the subset of hedge fund activists in lead-up periods before activists disclose adjustments in target firm ownership. Activist trading widens target bid-ask spreads and increases Amihud illiquidity (Amihud (2002)). These effects intensify as hedge funds trade physically closer to their targets. Close hedge fund trading before earnings surprises impounds the news into stock prices faster than other activists, reducing abnormal announcement return volatility by 29 percent. I conclude informed trading produces a trade-off between lower liquidity through adverse selection costs and more informative prices.