A new paper looks at how hedge funds adjust their information acquisition and trading behavior as analyst coverage changes—and more specifically, when certain stocks cease to be covered by certain analysts.
These authors considered the hypothesis that, faced with a murkier environment, hedge funds might become more cautious, reducing their trading activity. They found that this is not the case. On the contrary, “after exogenous reductions of analyst coverage due to closures of brokerage firms, hedge funds scale up information acquisition.” The funds trade more aggressively. Importantly, this proves successful. The funds earn higher abnormal returns after the coverage reduction.
What is Happening
It appears that the hedge funds are profiting by trading with parties who are left in the dark by the reduction of coverage. The hedge funds themselves scale up on acquisition in order not to be left in the dark. Also related, the participation of hedge funds in a particular market space “significantly mitigates the impairment of market efficiency caused by coverage reductions.” There is a substitution effect. Hedge fund activity steps in to get prices to the right level, the efficient level, when broker analysts step off stage.
The lead author of this paper is Yong Chen, of the department of finance, Mays Business School, Texas A&M. Wei Wu, also of Mays, is a co-author, along with Bryan Kelly of the Yale School of Management. They acknowledge that it is tricky to nail down as an empirical matter the question of the consequences of changes in coverage. After all, there is a “reverse causality” problem. What we believe is a case of A causing B could be a case of causing A. Activist hedge funds, after all, may demand that firms change their disclosure policy, and this may have the effect of reducing analyst coverage.
There also may be omitted variables in the way of ascertaining directly the impact of A on B. For example, “when there are important corporate events, such as mergers and acquisitions, the coverage decisions of sell-side analysts and the trading activities of sophisticated investors can change simultaneously.”
But the specific case of brokerage closures or mergers suggested itself to these authors as a “natural experiment” and the solution to such difficulties. Such changes in the structure of the brokerage market are not likely to be reverse causation. Previous studies have indicated that declines in analyst coverage “have no predictive power over future earnings of affected stocks.” They are “driven by adverse regulatory changes and unfavorable business conditions in the equity research industry.”
Analysts, Insiders, and Hedgers
In order to assess the consequences of such closures for market efficiency, the authors needed a metric for efficiency. For this they drew upon post-earnings announcement drift (PEAD), a phenomenon identified more than half a century ago, in a Ball and Brown paper in the Journal of Accounting Research in 1968.
Their work makes a case that analysts do contribute to price discovery. From another but related point of view, Wu recently contended that after the closures of brokerage firms, “corporate insiders earn higher abnormal returns on the affected stocks.” They benefit presumably in much the same way that hedge funds benefit—the insiders still have their own flashlights with them when the lights go out for less sophisticated investors.
The difference is that the insiders have their flashlights for free, so to speak, whereas hedge funds must build their own, hence the scaling up.
One might make of this an argument against the prohibition of insider trading. After all, if market efficiency is a good thing, and if the insiders are among those who step up to provide it when exogenous circumstances create inefficiencies, then the public would benefit by allowing more of it. The authors don’t really take their argument there, except briefly to observe that “insiders whose trading volume is much smaller than that of institutional investors are less likely [than the scaling hedge funds] to have substantial impacts on market efficiency.”