Hedge Funds and Wall St. Analysts: Insider Trading?

A study of large hedge funds found systematic trading on analysts' stock ratings before publication of their outlooks.

(April 16, 2014) — Large hedge funds are making profitable trades on “information leakage” of analysts’ buy/sell ratings before they are published, according to a study.

Researchers April Klein and Anthony Saunders of New York University’s Stern School of Business, and Yu Ting Forester Wong of Columbia Business School found hedge funds took advantage of private information in ways other financial players did or could not.   

“Opportunistic trading patterns surrounding analysts’ recommendation changes are limited primarily to large hedge funds, and cannot be extended to other large institutional traders” such as banks, insurance companies, and large growth-oriented mutual funds, the authors wrote.

Motivation for trading before analysts’ recommendations go public was in the potential for excess returns, the paper said. “A necessary condition behind the information leakage hypothesis is that investors can earn abnormal stock returns by trading prior to the release of recommendation changes.”

Pre-recommendation trading could earn hedge funds positive alphas for purchases and avoid significant losses for downgrades, the authors found.

According to its data, hedge funds earned an average annualized abnormal return of 9.96% for rating upgrades and were able to avoid an average loss of -11.28% on downgraded stocks.

The study included 57 hedge funds with over $10 billion in managed assets between 2006 and 2011. The authors compared their form 13F filings to the US Securities and Exchange Commission (SEC) to announcement dates for more than 70,000 analysts’ recommendation changes in the same time period.

“Since daily or intra-daily trades by hedge funds are not publicly available, our research design relies on aligning recommendation changes close to quarterly-end dates from hedge fund form 13F filings,” the authors said. “Thus, we are unable to conclusively determine the exact date of the hedge fund trades.”

However, these comparisons revealed that pre-trading could occur up to two days prior to the public issuance of the recommendation change, “consistent with hedge funds having advanced notice of the date of public release,” the paper concluded. It also found funds were more likely to trader earlier for downgrades than for upgrades.

“They are supposed to be among Wall Street’s most closely guarded secrets: changes in research analysts’ views, up or down, of a company’s prospects,” wrote Gretchen Morgenson, a columnist for The New York Times, in 2012. “But some of the nation’s biggest brokerage firms appear to be giving a handful of top hedge funds an early peek at these sentiments—allowing them to trade on the information before other investors get the word.” 

In 2013, Citigroup Global Markets paid a $30 million settlement to the state of Massachusetts over allegations that one of its analysts leaked private research to four large investors a day before its official release on Apple’s demand for iPhones. Last year, BlackRock likewise settled with the New York attorney general’s office to “end its ‘global analyst survey program’ aimed at ‘front-running’ changes in sell-side analysts’ recommendations,” according to the paper.

Because of the potential gain for investors with such nonpublic information, regulatory rules prohibit brokerage firms from leaking reports.

Despite the risk of potential legal consequences, analysts’ compensation structures still compel them to release their recommendations early, Klein, Saunders, and Wong wrote.

“Analysts’ compensation depends directly on the usefulness that their services provide to their hedge fund clients, with the most ‘useful’ analyst receiving the highest ratings,” the authors argued. A 2013 survey of sell-side analysts also revealed that 67% of respondents said their standing in analyst rankings or broker votes was “very important” to their compensation. 

Analysts may also feel pressured to provide larger hedge funds with information to maintain relations between certain funds and their firm’s investment banking arms, according to the paper.

“We find that each hedge fund trades more actively on upcoming recommendation changes made by one or two brokerage houses’ only,” the authors said. “The finding is consistent with the proposition that any leakage of information occurs between one (or two) brokerage house(s) and his/her preferred clients.”

Read the full paper here.

Related Content: SEC to Probe PE and Hedge Funds