Brokers may be leaking their best trade ideas from clients to other institutional investors, according to a paper from the National Bureau of Economic Research.
After a major broker executes a well-informed trade for one client, a “significantly higher volume” of other institutional investors execute similar trades through the same broker, authors Marco Di Maggio, Francesco Franzoni, Amir Kermani and Carlo Sommavilla said in a paper this month.
Their findings suggest brokers share information on trade orders, making it possible for investors to “free-ride” on a client’s good idea. Examining data from Abel Noser Solutions on trades executed through brokers from 1999 to 2014, the researchers found asset managers may receive tips about moves made by activist investors before they’re disclosed in public documents.
“We can imagine an informed trader submitting an order through a broker, who can infer the informational content of the trade and spreads it to other clients, especially the ones with the closest ties,” the authors said in the paper. “The incentive for the broker is to build a reputation as a valuable source of information and attract more business.”
The study found that “central” brokers — large firms with more access to information — performed “significantly better” than their more “peripheral” peers, even when controlling for size advantages.
In turn, the clients of these brokers – particularly the most frequent clients – earned more on their commissioned trades.
“Managers with the strongest relationships with central brokers capture, on average, higher excess returns for each trade,” the authors wrote. “The ultimate explanation of higher profits accruing through central brokers needs to take the strength of the broker-client relationship into account.”
Di Maggio and his co-authors found that when an activist investor executes a trade through a broker, other clients of that broker tend to buy the same stocks prior to the filing of a 13D.
“There are ten days in which the only market participant knowing about the activist’s trades is the broker,” they wrote. “This strongly suggests that these investors were made aware of the interest in that particular stock by the broker.”
Although they acknowledged the possibility that the original well-informed client could resent having their good idea spread around, the researchers said managers may be willing to accept having their own trades leaked with the assurance that they will be on the receiving end of future information leaks.
“An important source of alpha for fund managers is the access to better connections rather than superior skill,” they said.