Do Hedge Funds Trade on Private Information? Evidence from Upcoming Changes in Analystss Stock Recommendations

Abstract

Two large financial institutions recently settled allegations of selective disclosure of private information from supply-side analysts to hedge fund clients. These allegations lead us to explore two research questions: How widespread is this transfer of private information between analysts and hedge funds? Is there evidence that hedge funds trade advantageously on this private information? Using quarterly hedge funds holdings, we find evidence consistent with the view that large hedge funds traded profitably on upcoming analysts’ recommendation changes. First, we find a positive correlation between hedge fund trades and future changes in analysts’ stock recommendations (issued up to 2 days ahead of trades). However, we do not find a similar trading pattern for other institutions, such as banks, insurances companies and growth-oriented mutual funds. Second, individual hedge funds tend to trade prior to recommendation changes issued by a small number of brokers only, suggesting a favored hedge fund-brokerage house relationship. Third, hedge funds act as transient investors on trades made prior to recommendation changes, but act as longer-term investors for their other trades. Lastly, we provide evidence that hedge fund trades are profitable only when they are accompanied by a recommendation change. When hedge funds trade in equity with recommendation changes, they earn an annualized abnormal return of 9.96% for upgrades and avoid an annualized abnormal loss of 11.28% for downgrades. In contrast, abnormal returns on other stocks are not significantly different from zero.