Do Hedge Funds Trade on Private Information? Evidence from Analysts Recommendation Changes

• In Event: Audit Effectiveness and Market Reactions

Abstract

A recent New York Times article reported that analysts answer questionnaires from some of their largest hedge fund clients. This leads to a controversial question: Do these questionnaires merely provide public information, or do they alert hedge funds to future shifts in analysts’ views? Using quarterly hedge fund holdings, we find evidence consistent with the latter. First, we find a positive correlation between hedge fund trades and future changes in analyst recommendation (issued up to 2 days ahead of trades). However, we do not find a similar trading pattern in other institutions such as banks and insurances companies. Second, each hedge fund’s abnormal pre-recommendation trade is significantly higher for recommendations issued by a small number of brokers. Third, we find evidence that such pre-recommendation trades are temporary. Following analyst upgrades, over 21% of purchases were fully reversed in the next quarter; following analyst downgrades, over 13% of sales were fully reversed. In contrast, reversals for purchases and sales unaccompanied by forecast revisions are 0.2% and 1.5%, respectively. Lastly, we provide evidence that hedge fund trades are only profitable when it is accompanied by a recommendation change. When hedge funds trade in equity with recommendation changes; they earn an annualized return of 11.46%. While return from trades in other stocks is not significantly different from zero.

Authors

• April Klein, New York University

• Anthony Saunders, New York University

• Yu Ting Forester Ting Wong, Columbia University