With a reputation for secrecy and a penchant for confidentiality, the hedge fund industry hasn’t yielded a bumper crop of empirical data for researchers to feast on. One of the few square meals academics have been able to find is the ubiquitous 13F filing. Regular readers of this website are familiar with our rich vein of hedge fund data. Although these quarterly SEC filings cover only large long equity positions held by hedge funds (and all other institutional investors), they provide a rare insight into the skill of hedge fund managers. This study, for example, uses 13F’s to judge whether hedge fund managers mis-mark their equity positions. This one concludes that despite what you might expect, investors do not mimic Warren Buffett’s 13F filings. Another tries to do a sanity-check on hedge fund databases. And this guest contributor uses 13F filings to mimic the holdings of hedge fund managers.
Corners of the hedge fund industry have always guarded their “trade secrets” for fear that others might take advantage of this information to trade against them (witness LTCM for example) or simply copy them at a lower cost. So, with a rising chorus of politicians calling for “greater hedge fund transparency” (latest example: California senate candidate Carly Fiorina), it’s ironic that one of the few glimpses into hedge fund holdings may actually provide managers to a chance to fool copy-cats at their own game. A study by Stephen Brown of NYU and Christopher Schwarz of UC Irvine finds that transparency (in the form of 13F filings) can provide opportunities for some investors – including the very hedge funds filing these reports – to profit.
Investors have 45 days to spill the goods on their positions each quarter, and most hedge funds use all of that time. In large part due to the growing cadre of investors who trade on this information, Brown and Schwarz find that trading volumes peak about a week after each 13F is filed. Makes sense, right? But what startled the duo was that trading volume also peaked right before the filing deadlines. The chart below from the paper shows the daily and cumulative abnormal daily trading volumes around 13F filings made by hedge funds.
Okay, so volumes go up right before and right after hedge funds’ 13F filings are made. But do the stocks listed in these filings produce abnormal returns? It turns out the answer is “yes” and “no”. Although the duo found that these stocks didn’t outperform other stocks in the long term, they did produce excess returns on and immediately following the filing of a 13F containing that stock. (see chart below from paper)
(Note that daily excess returns peak on days 0 (filing date), 1 and 2 – days when volume is minimal according to the chart above. Once volumes picked up, excess profits tailed off.)
Okay. So these stocks tend to produce abnormal returns right after a filing. But what if the 13F shows a hedge fund is cutting its position in a stock? Does that mean the stock will go down after filing? Curiously, Brown and Schwarz find that it does not. As they explain:
The results are consistent across both Buys and Sells indicating investors appear to target all of the holdings disclosed rather than just the securities with expanded positions…
They go on to say that contracted stocks doesn’t produce as much excess return right after filing. But the bottom line is that it’s like they say in the PR field: It doesn’t matter if the news is good or bad, as long as they spell your name right.
As a result, you’d actually do better if you went long “expanded” positions and simply shorted the market rather than shorting “contracted positions.” The chart below from the paper shows the cumulative excess return (with 95% confidence interval) of going long expanded positions and short contracted ones…
And here is the result of going long expanded positions and shorting the entire market (i.e. to hedge out beta and isolate alpha).
And this is the ironic part. The authors suggest that the very act of disclosure creates an opportunity for the hedge fund manager to game the copy-cats by, for example, front-running their own 13F disclosures. Diabolical, we know, but technically very possible.
To explore this possibility, Brown and Schwarz use “Trade and Quote (TAQ)” data to determine if the spikes in volume noted above were buyer-initiated or seller-initiated. It turns out that this spike in trading is buyer-initiated, especially “where a position has been expanded from a previous quarter.”
This makes sense after the filing date, when copy-cats load up on hedge fund favorites. But it’s also the case before the filing date – at a time when the filing might be considered insider information.
Transparency is a complex phenomenon. Before politicians demand greater “transparency” from hedge funds, they might be well served by reading this paper. It seems that a little transparency can easily be worse than no transparency at all.