Nathan Swem, an economist with the Board of Governors of the Federal Reserve System, has written a paper on an always fascinating subject: the flow of information in financial markets.
The point, in successful equity trading for example, isn’t merely “who you know?” Nor is it “what you know.” It’s “how soon do you know it?” And that, alas, is a question not entirely unrelated to who you know.
After looking at the timing of information acquisition among sell-side analysts and institutions, Swem concludes that the trading by hedge funds uniquely predicts the direction in which stock analysts will subsequent change their ratings.
Intriguingly, Swem finds that hedge funds perform best among stocks that get a lot of analyst coverage. The implication of this is that hedge funds aren’t profiting by fishing in neglected pools, analyzing stocks otherwise ignored. They generate alpha, rather, by analyzing stocks to which others are paying attention. Perhaps they’re simply doing a better job of it than those others. But perhaps the fact that the pool is crowded assists their own prospects.
Or, to be more precise, hedge funds win by fishing in the crowded pools because some of the other fishermen help drive the fish, toward their boats. Analysts get the word “this is a good pool” to the later informed investors. Those later-informed investors provide liquidity, letting the earlier-informed hedge funds unwind their trades.
Buy, Wait for Upgrade, then Sell
After sell-side analysts publish reports upgrading certain stocks, hedge funds typically sell those stocks. The pattern suggests, as Swem puts it, “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.”
Swem of necessity discusses whether there are private communications between analysts and hedge funds. Obviously, if the hedge funds know that a prominent analyst is about to publish a report saying “XYZ is a great stock,” then there is no especially keen ‘angling’ required for the hedge funds to snap up XYZ before the report comes out and then sell it into the heightened interest the report itself creates.
Swem’s findings are, he says, “consistent” with the view that some analyst tipping occurs, but they also “indicate that tipping cannot completely explain the degree to which hedge fund trades anticipate sell-side analyst reports.”
His central point is that the flow of information often goes the other way, when hedge funders communicate (privately or publicly) with analysts. The largest hedge funds pay the highest brokerage commissions, to the biggest brokerage firms, so one might reasonably hypothesize that the sell-side analysts at the largest brokerage firms pay heed to what hedge funders are laying down for them. The hedge fund traders can buy, tell an analyst they have done so and make a case, wait for the upgrade, then sell. Or they can do the reverse. They can go short, tell a friendly analyst, wait for the downgrade, then sell.
Data bears this out. The trades of the large hedge funds predict the changes in the calls made by sell-side analysts at the larger brokers, the ones that cater to those same hedge funds. Smaller hedge funds’ trades predict the analyses of the smaller brokerages that in turn cater to them.
Sometimes hedge funds are quite open in making their privately generated information or analyses available. This happens, as Swem observes, at the annual Ira Sohn Conference. One notorious example: in May 2008 David Einhorn, of Greenlight Capital, gave a very perceptive (and accurate) talk on the likelihood that Lehman Brothers would soon come under pressure. Lehman collapsed, putting a crescendo on the global financial crisis, four months later. Einhorn again made news at Ira Sohn discussing The St. Joe Company in 2010, and William Ackman, Pershing Square, did the same discussing Herbalife in 2012.
In such a case the analysts can find themselves scrambling to keep up with what the hedge funders are disclosing.
Likewise, in some cases hedge funds publish their research analyses directly, without waiting for a conference as platform. Swem cites a recent article by Alexander Ljungqvist and Wenlan Qian in the Review of Financial Studies, which discusses that practice in a “limits to arbitrage” context.
The gist of Swem’s argument, though, is that “sell-side analysts assist hedge funds by making their information more widely known,” and that often this is information passed along to them by private communications from those hedge funds. The “tipping” goes in the opposite direction from what one might guess on the face of things (although tipping in one direction does not exclude the fact of tipping in the other).