As hedge funds and sell-siders tango, regular investors foot the bill: James Saft

This of course raises the salient issue of who the losers are, but you probably already know the answer to that.

Hedge funds, company stock analysts and shareholders form an ecosystem in which the hedge fund is the apex predator and the sell-side analyst is just the enabler. The average shareholder is the poor sap who makes the whole exercise profitable for the other two.

That’s the implication of a newly revised study by the Federal Reserve which investigates the way in which information flows in financial markets: who gets it first and who trades on it when.

“My results show that certain investors acquire information before sell-side analysts, and that sell-side analysts assist early informed investors by making their private information more broadly known,” Nathan Swem, an economist at the Board of Governors of the Federal Reserve System writes in the study. (here)

These “certain investors” are hedge funds.

“My results also suggest that investors strategically communicate their private information to sell side analysts to accelerate the incorporation of their information into prices.”

In other words, it isn’t that hedge funds are finding out about what a sell-side analyst is going to say beforehand and then positioning to benefit from it but rather that hedge funds are feeding analysts information and then cashing out on positions they previously established.

That’s suggested by Swem’s analysis of trades by a range of investors from hedge funds to mutual funds as compared to analyst reports and company news announcements. The study followed trades, reports and stock movements from 2004-2014, detailing the actions of 1,356 hedge funds and more than 2,500 other investment vehicles such as mutual funds.

In the bad old days before the tightening of financial disclosure laws analysts sometimes obtained non-public information and then retailed it in the most economically efficient manner, giving first shot to their firms’ biggest clients, many of whom were hedge funds.

The game now has changed somewhat, and hedge funds, which have grown in market share even as active long-only managers have declined, are now playing a different role.

TRADING AGAINST ADVICE

Unlike all the other types of investors in the study, hedge funds actually trade in the opposite direction to the advice of sell-side analysts, selling in aggregate in upgrades and buying on downgrades.

“I find that hedge funds are unique: they trade in the opposite direction as the sell-side reports recommend,” Swem writes.

“For example, after sell-side analysts publish upgrade reports I find that hedge funds sell. These patterns suggest that hedge funds anticipate sell-side reports, and then reverse their trades after market prices have adjusted to the information contained in, or coinciding with, the analyst reports.”

What’s more, the more heavily a company is covered by analysts the better the risk-adjusted returns hedge funds generate on these trades.

When analysts issue reports, the stocks at issue have an abnormal return of 3 to 4 percent up or down, depending on whether the report contains positive or negative news. Sometimes the sell-side analyst reports themselves contain new information but often they are issued just after a piece of news about a company breaks.

Some of what is happening likely is that hedge funds are obtaining non-public information and then trading after it is announced by companies, something that often prompts an analyst report. Yet the idea that hedge funds do tip analysts off as to non-public information is suggested by hedge fund trades that anticipate both earnings season reports and “influential” reports by analysts which move the market.

Earlier research has indicated that investors with superior information like to “fish in crowded pools,” preferring to get and exploit their information in highly covered, highly liquid stocks which give them more opportunities to get in and out of a stock and trouser their profits.

In addition, the trades of the largest hedge funds most strongly predict the more influential sell-side analysts reports, those that move markets.

But why? Well, imagine you are a hedge fund and you’ve obtained, perhaps through talks with company officials, information you think will move the share price. You then build a position, wait a bit and feed the information to a sell-side analyst who incorporates it into their own reports, which on publication moves the market and creates the liquidity you, the hedge fund, need to realize your gain. You are trading against the advice of the sell-side report not because you disagree but because you knew the market-moving information earlier and got in, or went short, based on that early knowledge.

To be sure, the study does not prove this, but it certainly suggests strongly this is what is happening.

The work of the regulators ensuring a level playing field is far from over.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)