The Sell Side is in Cahoots with Hedge Funds? Uh, duh…

The Sell Side is in Cahoots with Hedge Funds? Uh, duh…

April 29, 2014 Research Insights
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(Last Updated On: January 18, 2017)

Do Hedge Funds Trade on Private Information? Evidence from Upcoming Changes in Analysts’ Stock Recommendations

Abstract:

Two large financial institutions recently settled allegations of selective disclosure of private information from supply-side analysts to hedge fund clients. These allegations lead us to explore two research questions: How widespread is this transfer of private information between analysts and hedge funds? Is there evidence that hedge funds trade advantageously on this private information? Using quarterly hedge funds holdings, we find evidence consistent with the view that large hedge funds traded profitably on upcoming analysts’ recommendation changes. First, we find a positive correlation between hedge fund trades and future changes in analysts’ stock recommendations (issued up to 2 days ahead of trades). However, we do not find a similar trading pattern for other institutions, such as banks, insurances companies and growth-oriented mutual funds. Second, individual hedge funds tend to trade prior to recommendation changes issued by a small number of brokers only, suggesting a favored hedge fund-brokerage house relationship. Third, hedge funds act as transient investors on trades made prior to recommendation changes, but act as longer-term investors for their other trades. Lastly, we provide evidence that hedge fund trades are profitable only when they are accompanied by a recommendation change. When hedge funds trade in equity with recommendation changes, they earn an annualized abnormal return of 9.96% for upgrades and avoid an annualized abnormal loss of 11.28% for downgrades. In contrast, abnormal returns on other stocks are not significantly different from zero.

Alpha Highlight:

This paper empirically addresses something that everyone in the hedge fund business already knows–the biggest fee payers on the street basically “own” the sell-side analysts. If you didn’t know about this sweetheart relationship, well, you do now.

First, there is clear evidence that trading ahead of analyst upgrades and downgrades would provide some great returns:

SSRN-id2421801
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

When the authors look at the performance of hedge fund stock holdings that are associated with analyst reports and those that are not, they find a clear pattern: all the alpha is in the stocks they are trading that have upgrades/downgrades attached to them.

evidence
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Pay more fees to the banks, get more front-running opportunities…and we wonder why nobody trusts Wall Street…


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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.