How Hedge Funds Exploit Sell-Side Analysts

Hedge funds may be feeding information to stock analysts to better profit off their own trades.

In a new paper released by the Board of Governors of the Federal Reserve System, Fed economist Nathan Swem analyzed the relationships between institutional investors and sell-side analysts to determine who obtained financial information the fastest. Swem found that hedge funds were most aggressive and “strategically disclose their private information to sell-side analysts” to influence stock prices and profit from their slower competition.

While mutual funds, broker dealers, and pension funds “rely heavily on the information contained in sell-side reports” to make trades, hedge funds typically behaved in opposition to analyst recommendations, according to the paper. They used their “superior information acquisition skills” to make trades ahead of the sell-side reports – buying a stock before analysts told investors to buy it, and then selling it at a profit when everyone else bought it.

“Sell-side analysts assist hedge funds in profitably exploiting their information acquisition efforts,” Swem wrote in the paper.

Their information acquisition skills, he said, include techniques such as “extracting information from private meetings with corporate management teams” and “aggressively” filing Freedom of Information Act requests to financial regulators.

For the study, Swem used data from 13-F filings tracking the stock holdings of hedge funds, brokerage firms, pension funds, and mutual funds between 2004 and 2014. He found that “despite defying sell-side analyst recommendations, hedge funds generate higher risk-adjusted returns among stocks with higher sell-side analyst coverage” – with performance increasing as analyst coverage increased.

Given that hedge fund trades predicted analyst recommendations, Swem hypothesized that analysts could be tipping hedge fund managers off ahead of publishing their reports. However, his research suggested only that private communications flowed between hedge funds and analysts – meaning hedge funds could just as easily be the source of information.

“The positive relation between hedge fund performance and sell-side analysts coverage provides strong evidence that sell-side analysts assist hedge funds by making their information more widely known,” Swem said in the report.