Buy the rumor and sell the fact, they say. Another way of stating that is that the value of information is inversely correlated with the number of people who know it. For a trader, one reliable way of staying on the right side of that dynamic is to get chummy with a big sell-side analyst, whose recommendations, once published, move stocks. That this isn't strictly legal doesn't change the fact that it happens.
But that's not the only direction information can flow. A new study probing the way hedge funds anticipate analyst recommendations – they do – uncovered an unexpected relationship: It's not just in the few days before an analyst report that hedge funds begin trading in the right direction. Sometimes the trades precede the reports by several weeks, suggesting that it's not analysts tipping off the funds but sometimes the other way around. In other words, hedge funds might also buy the fact and sell the rumor.
The study's author, Fed economist Nathan Swem, explains:
I find that the direction of hedge fund trades positively correlates
with the direction of subsequently published sell-side upgrade and downgrade reports […]. These market reactions suggest that the reports contain new fundamental information, as in Loh and Stulz (2011), and/or that analysts publish reports when fundamental information is disclosed, as in Altinkilic and Hansen (2009). In either case, my results indicate that hedge fund trades begin incorporating important fundamental information before the information becomes more broadly known.
You can interpret the pattern in various ways. Hedge funders might be sniffing up the same tree as analysts. Or they might be getting some valuable texts from their sell-side buddies. The private communications could involve insider-y shenanigans, but they might also just be general information sharing between hedgies and analysts, along the lines of “Hey, Acme Widgets sure is having a nice quarter.”
As a big survey of analysts conducted a few years ago suggested, these sort of conversations go down with some frequency. Here's one (anonymous) analyst on those dynamics from that study:
“Regardless of Reg FD, investors value analysts’ direct contacts with management more than anything. As an analyst, if I call up a money manager, a hedge fund, whoever, and I’ve got a call to make on a stock, and I’m able to say, ‘Hey, by the way, we were able to spend 20-30 minutes talking to senior management,’ boom! Their ears are just straight up.”
So analysts might sometimes leak info to their loyal hedge fund clients. We already knew this. What's interesting is the reverse movement. Swem:
I also find that hedge fund trades predict analyst reports made 10, 20, even 30+ trading days into the following quarter. These results suggest that analyst tipping may be occurring, but also indicate that tipping cannot completely explain the degree to which hedge fund trades anticipate sell-side analyst reports […]. Communicating information to sell-side analysts, in order to influence the content of subsequent sell-side reports, is an additional mechanism by which a hedge fund, or any institutional investor, can accelerate the incorporation of their private information into prices.
The basic theory here is that hedge funders might be better at sniffing out nuggets of valuable info than their banking peers. If Glowering Bluff Management somehow finds that Acme Widgets is about to land a big government contract, they'd obviously want to trade on that. But why not sweeten the trade by sharing the tip with the fund's broker-dealer for inclusion in a future research report? Then, once the broader investing public knows, pocket the winnings.
Analysts have their own set of incentives. As Swem notes, hedge funds are the most lucrative source of brokerage commissions. Since one would expect the largest funds to team up with the most influential analysts, the correlations should be large amongst the biggest fish. Indeed, Swem writes: “Consistent with strategic information disclosures, I find that the trades of large hedge funds more strongly correlate with large brokerage firm analysts.”
The final takeaway here is that, in order for these strategic disclosures to be useful to hedge funders, they tend to concentrate on heavily traded stocks. What use is it to send a nice tip to an analyst if no one is going to read, let alone trade on, the subsequent report?
Who knows whether there's anything actionable in all this for all the stock-picking plebs out there trading on analyst reports stale enough to have been published. But at least now they know who it is that's selling after that big upgrade.