Do Hedge Funds Manipulate Stock Prices? (Digest Summary) (2024)

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 conflictwith arbitrageurs’ motivation to attract and retain investment capital.

The authors first explore this notion by examining hedge fund management company holdingstogether with stock prices to ascertain whether the degree of manipulation is sufficient toaffect stock prices. They then discuss their results with regard to the current debate aboutmore extensive hedge fund regulation. The authors develop sophisticated statisticaltechniques that uncover ambiguous asset price manipulation; regulations, in contrast, aretypically 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 moderatinginfluence on markets, but the authors challenge this idea. They postulate that hedge fundsare inherently conflicted in their role as arbitrageurs because of their strong incentive toattract and retain investment capital. This conflict can motivate some hedge funds toincrease their buying activity in select stocks, thereby creating a demandimbalance—the very thing arbitrage activity is supposed to prevent—which thenartificially inflates the stock prices. In this way, the authors help identify the source ofsome abnormal stock price movements.

By examining hedge fund holdings and their returns, they test their assertion that hedgefunds manipulate stock prices at month-end to pump up the returns of their portfolios toattract and retain investment capital. They find evidence to support their assertion at thestock level and the hedge fund company level. Stocks with significant hedge fund ownershipexhibit abnormal monthly returns near the market close. This timing ensures that otherplayers do not have sufficient time to adjust prices to correct the order imbalance. Theprices then reverse the following day soon after the market opens. The trading activity isconcentrated 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’sprice 1% during trading hours but that manipulating closing prices requires substantiallygreater capital. Such plausible alternative influences on the returns as higher portfolioinflows and asset reallocation are tested to ensure the results are robust.

The authors’ work complements the existing literature on price manipulation. Previousstudies have uncovered price manipulation by mutual funds and short sellers, and the authorsfind evidence that this pattern extends to hedge funds. The focus of the manipulation onmonthly returns coincides with the importance that existing and potential hedge fundinvestors place on this measure as a proxy for fund performance. But the manipulation alsoaffects areas (e.g., executive compensation contracts and manager compensation fees) andorganizations (e.g., industry regulators) that rely on marked-to-market pricing. Thesophisticated techniques introduced here to detect price manipulation would benefit theseaffected parties. Manipulation seems to have persistence, with hedge funds tending to repeatmanipulation in multiple quarters.

How Did the Authors Conduct This Research?

Eight hypotheses are formulated to organize the research around various aspects of hedgefund price manipulation. The primary dataset is a collection of hedge fund company namesfrom Thomson-Reuters (TR), mandatory US SEC institutional quarterly holdings reports (13F),and descriptive statistics and performance for hedge funds (TASS) for the period of1Q2000–3Q2010. This period is chosen to coincide with the enormous growth in the hedgefund industry.

The benefits of the TR database are that it is more encompassing and provides granularitydown to the adviser level; the 13F data are reported at the consolidated level. The 13F datahave a number of other limitations: Short equity positions are not included; institutionswith assets under management (AUM) of less than $100 million in US equity are excluded, asare positions smaller than $200,000, or 10,000 shares; and only quarter-end holdings areused. 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) andpeaks with 552 (in 2006). The average amount of AUM is $230.4 million, and the average hedgefund ownership is 2.6% of outstanding shares. For daily stock returns and stockcharacteristics, the authors use CRSP and Compustat databases. Intraday trade data areobtained 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 beenduped, especially considering that the appeal for many investors is hedge funds’ lowcorrelation with general market movements and that the authors find clearer pricemanipulation in quarters with poor market returns. Even more sobering is that themanipulation, although unethical, is fully compliant with legal requirements. Regulationsare either too diluted or just plain ill-equipped to detect price manipulations of thiskind, but the authors do offer some encouragement in the form of sophisticated techniquesmore appropriate for monitoring these types of shenanigans.