Secrets don’t make friends: New research shows hedge funds gain information advantage from unique relationships with investment banks

GAINESVILLE, Fla. – Keeping a secret is often easier said than done, especially when there’s money on the table. For years, news outlets like The New York Times and The Wall Street Journal have written about investment banks allegedly giving their hedge fund clients preferential access to broad bank resources and information – information that could be used to gain an unfair advantage when it comes to trading stocks.

While the world may never know the whole truth about what is shared between investment banks and their hedge fund clients, new research from the University of Florida Warrington College of Business shows that hedge funds gain an information advantage from their prime broker banks in regards to the banks’ corporate borrowers.

Banks perform due diligence and collect valuable private information about corporate borrows before granting loans. The study finds not only do connected hedge funds make large trades in borrowing firms’ stocks prior to a loan announcement, they also perform better in their trades of such stocks compared to that of the study’s control group.

“The special relationship with the banks helps funds obtain ‘nuggets’ of information that are valuable either by themselves or when combined with other information signals these funds possess,” write researchers Nitish Kumar and Yuehua Tang of the Warrington College of Business, Kevin Mullally of the University of Central Florida and Sugata Ray of the University of Alabama.

By combining data on hedge fund prime broker banks, loan originations and hedge fund firms’ 13F stock holdings from 1994 to 2014, the researchers determined the benefits hedge funds receive from their unique relationships with investment banks. They show that a connected hedge fund on average generates additional abnormal profits of over $400,000 per quarter from their trades of the loan stocks compared to other trades. Furthermore, a trading strategy that mimics connected hedge funds’ buys and sells in the loan stocks outperforms a similar trading strategy that mimics the trades in the control group by over 1.3 percent per month.

Due to insider trading laws that state it is illegal to buy or sell securities based on material non-public information, the research calls into question whether or not the information shared between investment banks and hedge funds violates current law.

“In the context of our setting, the appropriateness of information transfer from banks to hedge funds depends on whether material non-public information changes hands and is subsequently traded upon,” Kumar, Mullally, Ray and Tang write. “If the information shared is material and not publicly available, our evidence of outperformance by connected funds would suggest a violation of insider trading laws.

“However, it is also possible that connected hedge funds obtain information that is nonmaterial on its own but becomes valuable once combined with information these funds already possess. For instance, hedge funds can combine pieces of information obtained from various sources to gain a deeper understanding of a company…under this scenario, investment banks’ provision of preferential treatment to hedge funds could be within the legal boundary.”

“Regardless of how connected hedge funds gain an edge, our results suggest that prime broker banks provide a valuable function of ‘information brokerage’ to hedge fund clients,” Kumar, Mullally, Ray and Tang write.

Kumar, Mullally, Ray and Tang’s “Prime (information) brokerage,” research sheds light on the importance of having a deeper understanding of the relationship hedge funds have with investment banks and how that relationship impacts regulation and governance in the finance industry.

The researchers advise regulators to pay close attention to this question of legality, as it could impact the integrity of the stock market and implies a potential distortion in the universal banking model.

“From the perspective of stock market integrity, shareholders of the borrowing firms are harmed by hedge funds enjoying an unfair, if not illegal, advantage due to their connections to prime broker banks,” Kumar, Mullally, Ray and Tang write. “Our findings [also] suggest that banks with both commercial lending and prime brokerage divisions can capitalize on the valuable information they possess about their corporate clients through their prime brokerage business.”

This research is forthcoming in the Journal of Financial Economics.