17th July 2012
Trust takes a new battering as analysts tell view to top clients first
Where does trust erosion stop? Investors have had to deal with the continuing Libor scandal, allegations that the gold market is rigged, and a G20 report suggesting oil prices are manipulated by traders.
It seems that the confidence investors once had that traders and others would use their savings fairly and not just to profit their bonuses could be misplaced.
Now, to add to all the other potential scandals, it appears, according to report in the New York Times, that some major hedge funds have had "sneak previews" of equity and bond analysis. This gives recipients an advantage over rivals who have to wait until the reports are officially released, leading investors to wonder if any markets are still controlled by Adam Smith's "invisible hand".
Predicting the reactions
Markets place a great importance on analysts' thoughts and recommendations – even those with less than a shining track record of success. Markets act on what they think others will do so a bond or equity report from a stockbroker or investment bank can carry substantial weight – they don't have to be proved correct providing one investor believes another will think the document points the way up or down.
Knowing the contents of a report before others see it enables the fund manager to set up positions well ahead of the field.
Laws banning insider trading, and other regulations preventing "front-running" are supposed to prevent this practice. But it was once widespread, seen as part of the culture.
In the UK, stockbrokers and fund managers used to provide share tips for the "Friday Night Drop". They would send or phone Sunday paper journalists details of equities that they already held in the hope that a favourable mention in a tipping column would push up the price. Some used public relations operatives – one used to deliver the tip as copy ready made for the paper.
And in some cases, brokers would send tips to the paper earlier in the week, knowing that some journalists would then trade on that or relay the information to others so the price went up – allowing the original source to sell the stock late on Friday afternoon. There were equally cosy relationships between brokers and fund managers.
Selected funds and selected brokers
However, all that is supposed to have stopped years ago. Apparently not if the New York Times story has credence. It says some of the biggest New York brokerage firms are giving selected major hedge funds an early look at views from their research analysts, enabling them to feed the information into their computers and trade ahead of other investors in scenes reminiscent of film Trading Places.
The paper alleges that a number of large hedge funds – receive results from surveys that analysts answer and submit electronically every month or every quarter. Of particular interest to hedge funds are analysts' responses to questions about possible unexpected earnings boosts or downgrades or losses at the companies they track.
According to the New York Times, analysts who have participated include those at Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch and UBS. Most major brokers have a number of large hedge funds as clients and would be loath to see them depart.
Besides putting rival funds at a disadvantage, the front-running harms private and self-directed investors.
Questions over Facebook
The New York Times says: "Questions about the selective release of analysts' views came up when the brokerage firms charged with selling Facebook's initial shares were found to have warned large buyers about some analysts' doubts regarding the company's prospects. That irked many small investors who had not received the guidance and sustained losses in their Facebook shares. The Securities and Exchange Commission is investigating these disclosures."
The newspaper says the practice is "systematic and growing" on Wall Street, according to documents it has obtained. The funds themselves say they ask only for public information. But the documents show, the paper claims, that in at least four cases, documents from Barclays Global Investors, (since sold to BlackRock) state that the goal is to receive nonpublic information.
The revelations will further destroy confidence in a system already battered by allegations of trader manipulation. Firms officially state that research is distributed to all clients at the same time.
Firms deny allegations
The firms named in the New York Times deny the allegations of front-running. BlackRock told the New York Times: "The language in the Barclays Global Investors internal memos is sloppy and inaccurate and totally inconsistent not only with the stated purpose of the survey but also with the high ethical standards by which BlackRock does business. The survey explicitly states that it requests only information that sell-side research analysts have already disseminated publicly and an analyst cannot even take part in the survey without first clicking a button to confirm that answers would be based solely on public information."
Representatives for Citigroup, UBS and JPMorgan Chase told the New York Times they have strict policies in place for analysts participating in client surveys, which require that their comments are consistent with their publicly held views.
Despite these denials, the paper insists it has seen confidential documents describing the surveys, where company officials clearly state that non-public information is what they are after. One confidential memo related how it could profits from an " earnings surprise direction that is in information not released to the market. " And the advance notice allowed the hedge fund to second-guess the analyst's view on other stocks more accurately.
Another document bluntly said: "We are trying to front-run recommendations," referring to trading ahead of analysts' recommendations.