As an investor – even an observer – we trust that well-functioning financial markets accurately reflect the value of companies. When you put money into stocks and shares, or when your pension fund or insurance company does so for you, you want to know the price is fair. But not everyone plays by the same rules. For centuries, there has been market manipulation. In 1814, for instance, deliberately spread rumours about the death of Napoleon led to a spike in prices of government securities at the London Stock Exchange. This is now known as the Great Stock Exchange Fraud of 1814. Some people use markets to their own advantage, never mind the consequences for everyone else. Among this group of potential manipulators, our work looks at modern-day hedge funds – professional investors often seen as skilled at stock picking and market timing. Unless you have a high individual net worth and access to substantial disposable funds – or represent a big institution ready to invest, at a minimum, around £500,000 – you are unlikely to find yourself among their direct investors. But indirectly, all market participants are affected by hedge fund trading. Hedge funds are active in derivative markets, and a large fraction of all short selling – where investors ‘borrow’ shares and sell them, hoping to buy them back later for a lower price – is done by hedge funds. They tend to exploit relative mispricing of securities, potentially making markets more efficient and fairer for all. But what if they are cheating? PUMP IT UP In the 2000s, hedge funds operated in a traditionally lightly regulated area, with few reporting requirements. Those that were in place did not even apply to all funds. The industry was growing rapidly, with cash flowing in. The opportunity for manipulation was there, and it was taken. Between 2000 and 2010, as a collective, these funds engaged in a ‘pump and dump’ or ‘portfolio pumping’ strategy. This involved buying more stock of which they already have a stake on the last day of a quarter – when funds are expected to report their holdings. Their actions created artificial demand and inflated the value of the stock and, hence, the reported hedge fund portfolio. But just a day later, on the first day of the following quarter, the funds sold those exact same stocks, leading to a decline in their prices. Such trading created a ‘blip’ in stock prices, and it repeated itself quarter after quarter. The hedge funds involved gained through potentially higher investor flow – more people investing money, resulting in bigger fee payouts for fund managers as investors saw better reported performances and wanted in on the action. The practice was feasible because funds had free capital to finance the portfolio pumping. Our work looked at each individual stock traded on major US exchanges: the NYSE, AMEX and NASDAQ. At the end of each quarter, we calculated hedge fund ownership as the fraction of total shares outstanding by the company that is reported to be held by hedge funds and relate this ownership to price dynamics between the last day or a quarter and the following first day of a new quarter. The strongest pump and dump (blip) patterns could be seen for stocks with 16 |
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