When hedgies outshine their institutional counterparts

New research examines how hedge funds use insider information

Debate has long raged about who has the superior talent – hedge funds or mutual fund investors. Now the jury has returned its verdict, at least in one quite specific area of trading.

In their conference paper, Are hedge funds more skilled than other institutional investors? Evidence from their use of insider trading information, UNSW Business School researchers – senior lecturer Jianfeng Shen, professor Jerry T. Parwada and tutor Yixuan Rui – answer in the affirmative. The parameters are very narrow, however – the authors say that in terms of their use of (legal) insider trading information, the 'hedgies' come up trumps.

"Yes, in that context [they are more skilled]," says Shen. "There are lots of different skills, but we are just examining one of them."

Before considering the complex and often misunderstood realm of insider trading information, it is worth explaining hedge funds. Around since the 1940s, they are alternative investment vehicles typically available only to sophisticated investors such as institutions and very wealthy individuals.

While the name inherently suggests a safety-first approach, hedge funds are often more aggressively managed on behalf of investors seeking to generate high returns, whether that's in an absolute sense or compared with a market benchmark.

Hedge funds are also a sound means of diversifying an investment portfolio given that they often have low correlations with traditional portfolios of stocks and bonds.

'Are they more skilled? Of course, most hedge fund people will think that they are, but they are certainly more active. I think that's the key'


A different skill set

According to Neil Power, managing director of hedge fund strategies at Blue Sky Alternative Investments, hedge fund trading is undoubtedly "tricky" and requires traders who are pragmatic and possess real-world market knowledge while also having the quantitative skills to convert theory into algorithms.

"It's about balancing the theory and the practical – they both have to be present," says Power.

He notes that hedge funds clearly have a different trading approach to mutual funds and their primary goal should be to add diversification to a portfolio. On the contentious issue of whether hedgies are more skilled than their institutional counterparts, Power is diplomatic, saying it is more relevant to note that they are more active, short-term traders than their longer-term-trading mutual counterparts.

"There are some very talented long-only managers – it's an entirely different skill set and even within the broad hedge fund industry there's multiple different types of strategies and people and approaches.

"Are they more skilled? Of course, most hedge fund people will think that they are, but they are certainly more active – I think that's the key," says Power.

Legal insider trading

In their paper, Shen, Parwada and Rui zero in on the use of insider trading information. While most lay people associate insider trading with illegal behaviour – and infamous cases involving the Galleon Group, American homemaking guru Martha Stewart, the SAC Group's Steven A. Cohen and, more recently, Australian high-flyer Oliver Curtis – there is also legal insider trading.

This refers to a scenario where corporate 'insiders' – typically those in senior management positions – adhere to the rules as they buy and sell stock in their own company. These common types of trades are seen as a form of insider trading because company employees may have access to information that is not available to the general public.

These insiders need to report their trades to regulators (such as the Securities and Exchange Commission in the US) within a specific period to comply with the regulations.

However, this does not guarantee that these trades are legal; the SEC may subsequently investigate these trades and find that some are not. Importantly, once disclosed, the information about these trades (including who bought or sold the shares, how many were traded and at what prices) is available to the public.

As a result, after the disclosure anyone can observe the information and use it to facilitate their investment decisions. For example, if you hear an announcement that the Telstra chief executive officer has sold 5000 Telstra shares, you can analyse the trade and decide whether it means anything about Telstra's fundamentals and share prices.

Why do insiders trade?

 Shen, Parwada and Rui consider how hedge funds and other institutional investors use such information about insider trades. They examine hedge funds' use of insider trading data drawn from the Thomson Reuters insider filings database (1995-2013) and which has been legally disclosed to the SEC.

The research raises speculation about the potential motivations as to why insiders trade: are they information driven or liquidity driven? No definitive answer is possible, meaning the authors can only make inferences based on trading patterns.

For insiders who trade very routinely – for example, only in certain months during a period of a few years – they conclude that these people likely trade for liquidity motives. For other insiders who trade non-routinely, the researchers suggest these people likely trade due to their private information.

The authors state that though corporate insiders frequently trade for non-information motives, including a desire to have portfolio diversification and liquidity, they may also trade on their private information "given their incomparable access to information about a firm's operations and significant corporate events".

Driven by information

Parwada, Rui and Shen make two key conclusions. First, on average, hedge funds are more skilled than institutional investors at identifying informative insider trades.

The authors note that hedge funds tend to trade in the same direction as insiders when those trades are driven by information, but they do not respond to likely liquidity-driven insider trades; that is, those trades that occur when investors may, for example, be seeking cash or have too much money tied up in shares and want to rebalance their portfolio.?

"This finding is consistent with hedge funds being able to decipher insider trading information and trade accordingly," the authors state.

Second, even among hedge funds, the better they are at identifying such trades will likely lead to superior investment returns.

According to the authors: "By classifying insider trades into potentially informative ones and others likely driven by liquidity motives, we find supporting evidence for hedge funds' ability to identify potentially informative insider trades and mimic such trades.

"In contrast, mutual funds and other institutional investors on average act as liquidity providers to insiders, regardless of insiders' trade motives. We further develop a measure of hedge funds' ability to use insider trade information, and link such ability to their performance in the cross-section. We find that hedge funds more skilled at identifying informative insider trades tend to outperform others."

'This finding is consistent with hedge funds being able to decipher insider trading information and trade accordingly'


Keys to success

While they may have the edge in identifying insider trades, broader performance issues for hedge funds, particularly in the US, have come to the fore in the past year. Hedge funds' success in generating gains during the 2000-02 dot-com crash led many institutions to invest in them for the first time, but recently large pension funds in the US have been cashing in some investments in the aftermath of below-par returns.

Power says any successful hedge fund has to have two key things going for it – research and distribution. Ultimately, he says any fund must be judged by its performance and assets under management.

"If both those numbers are good, you'll do very well," says Power, adding that the aim must be at all times to serve the interests of clients and their portfolios. "You don't get any strikes just for being clever."

Shen and his co-authors conclude in the same vein: "The existing evidence generally suggests that hedge funds are more skilled than other institutional investors on average. More and more studies attempt to discover the sources for superior performance by hedge funds. We add to this line of literature by exploring a new source contributing to hedge funds' information advantage – insider trading information."



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