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1 November 2013 CFA Institute Journal Review

Do Hedge Funds Manipulate Stock Prices? (Digest Summary)

  1. Keith Joseph MacIsaac, CFA, CIPM

Some hedge funds manipulate stock prices on key reporting dates. The authors find that the returns of stocks with significant hedge fund ownership exhibit an increase of 0.30% on the last day of the quarter and a decrease of 0.25% the following day. The majority of the increase occurs near the market close and reverses the next day near the market open. Volume and order imbalance information reinforces these patterns, which are more prevalent when incentives to manipulate are stronger.

What’s Inside?

Arbitrageurs assume a vital role in financial markets by facilitating price convergence. This stabilizing force is often performed by hedge funds. But this role can be in conflict with arbitrageurs’ motivation to attract and retain investment capital.

The authors first explore this notion by examining hedge fund management company holdings together with stock prices to ascertain whether the degree of manipulation is sufficient to affect stock prices. They then discuss their results with regard to the current debate about more extensive hedge fund regulation. The authors develop sophisticated statistical techniques that uncover ambiguous asset price manipulation; regulations, in contrast, are typically focused on detecting misreporting or misevaluation of portfolio holdings.

How Is This Research Useful to Practitioners?

The conventional view is that hedge funds’ arbitrage activity provides a moderating influence on markets, but the authors challenge this idea. They postulate that hedge funds are inherently conflicted in their role as arbitrageurs because of their strong incentive to attract and retain investment capital. This conflict can motivate some hedge funds to increase their buying activity in select stocks, thereby creating a demand imbalance—the very thing arbitrage activity is supposed to prevent—which then artificially inflates the stock prices. In this way, the authors help identify the source of some abnormal stock price movements.

By examining hedge fund holdings and their returns, they test their assertion that hedge funds manipulate stock prices at month-end to pump up the returns of their portfolios to attract and retain investment capital. They find evidence to support their assertion at the stock level and the hedge fund company level. Stocks with significant hedge fund ownership exhibit abnormal monthly returns near the market close. This timing ensures that other players do not have sufficient time to adjust prices to correct the order imbalance. The prices then reverse the following day soon after the market opens. The trading activity is concentrated in illiquid stocks, which ensures the greatest impact on the overall portfolio. Notably, the authors find that it takes just $500,000 to move an illiquid stock’s price 1% during trading hours but that manipulating closing prices requires substantially greater capital. Such plausible alternative influences on the returns as higher portfolio inflows and asset reallocation are tested to ensure the results are robust.

The authors’ work complements the existing literature on price manipulation. Previous studies have uncovered price manipulation by mutual funds and short sellers, and the authors find evidence that this pattern extends to hedge funds. The focus of the manipulation on monthly returns coincides with the importance that existing and potential hedge fund investors place on this measure as a proxy for fund performance. But the manipulation also affects areas (e.g., executive compensation contracts and manager compensation fees) and organizations (e.g., industry regulators) that rely on marked-to-market pricing. The sophisticated techniques introduced here to detect price manipulation would benefit these affected parties. Manipulation seems to have persistence, with hedge funds tending to repeat manipulation in multiple quarters.

How Did the Authors Conduct This Research?

Eight hypotheses are formulated to organize the research around various aspects of hedge fund price manipulation. The primary dataset is a collection of hedge fund company names from Thomson-Reuters (TR), mandatory US SEC institutional quarterly holdings reports (13F), and descriptive statistics and performance for hedge funds (TASS) for the period of 1Q2000–3Q2010. This period is chosen to coincide with the enormous growth in the hedge fund industry.

The benefits of the TR database are that it is more encompassing and provides granularity down to the adviser level; the 13F data are reported at the consolidated level. The 13F data have a number of other limitations: Short equity positions are not included; institutions with assets under management (AUM) of less than $100 million in US equity are excluded, as are positions smaller than $200,000, or 10,000 shares; and only quarter-end holdings are used. But the 13F data have no survivorship bias, which can skew results.

The final sample begins with 309 equity-style hedge fund management companies (in 2000) and peaks with 552 (in 2006). The average amount of AUM is $230.4 million, and the average hedge fund ownership is 2.6% of outstanding shares. For daily stock returns and stock characteristics, the authors use CRSP and Compustat databases. Intraday trade data are obtained from the NYSE. All returns are risk adjusted to ensure comparability.

Abstractor’s Viewpoint

It is apparent from the authors’ results that some hedge fund investors have been duped, especially considering that the appeal for many investors is hedge funds’ low correlation with general market movements and that the authors find clearer price manipulation in quarters with poor market returns. Even more sobering is that the manipulation, although unethical, is fully compliant with legal requirements. Regulations are either too diluted or just plain ill-equipped to detect price manipulations of this kind, but the authors do offer some encouragement in the form of sophisticated techniques more appropriate for monitoring these types of shenanigans.

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