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E-MailMarco Di Maggio is Assistant Professor of Business Administration at Harvard Business School. This post is based on a recent article, forthcoming in the Journal of Financial Economics, authored by Prof. Di Maggio; Francesco A. Franzoni, Professor of Finance at USI Lugano; Amir Kermani, Assistant Professor of Finance and Real Estate at University of California Berkeley Haas School of Business; and Carlo Sommavilla, PhD student at USI Lugano and the Swiss Finance Institute. Related research from the Program on Corporate Governance includes The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.
Institutional investors routinely make use of brokers to execute their trades. Despite the rise of electronic trading, the Tabb Group reports that brokers handle about 42 percent of order flow from hedge funds. However, brokers’ roles in disseminating information that they acquire from clients is at best unclear. Although information about prices is readily disseminated in equity markets, brokers’ vantage points might allow them to extrapolate the informational content of an order and to anticipate the future behavior of prices. For example, they can condition on the identity of the trader and are aware of the order flow before it hits the market. In these cases, brokers might have an incentive to extract these informational rents by communicating and spreading the information to their clients.
Both brokers’ practice of selling order flow and regulatory scrutiny of potential information leakage provide anecdotal evidence for the conjecture that brokers play a pivotal role in directing information flow in the market. In our article we analyze a comprehensive trade-level dataset from 1999 to 2014 that contains the identities of both brokers and asset managers to show that brokers who execute trades on behalf of informed investors may extract the informational content of the orders and spread it to their other clients.
We provide evidence of this information leakage through three main tests. First, if brokers disseminate the information contained in informed trades, other investors should behave similarly to the informed ones. Evidence consistent with this hypothesis is gathered by investigating large trades executed by hedge funds (originators) that are profitable and anticipate a move of asset prices that is not followed by a reversal even after several months. This test finds that other investors (followers) are significantly more likely to trade with the same broker in the same direction of the large informed trade, while the broker is still executing the originator’s order.
Second, if brokers have access to superior information, they should release it selectively and in a way which allows them to extract the highest rents. Based on this logic, we show that brokers’ best clients—those with whom the broker made more profits in the past and from whom it expects to continue to receive business in the future—receive the information about other investors’ trades. We restrict attention to block trades where the originator has institutional ties with the broker and find that, in this case, the broker preempts competition from other traders.
The study’s main test focuses on activist investors. Activists are required to file a 13D form with the SEC within 10 days of reaching a 5 percent stake in a target company. They are unlikely to have an incentive to announce their intent before they build up their positions, as that would create unwanted competition from other traders. So, before the 13D filing, few market participants have information about activists’ trades, but the activists’ brokers know. We collected information about the dates and targets from the 13D forms as well as the brokers employed by the activists. This data allows us to show that the best clients of the activists’ brokers are significantly more likely to buy the stock of a target firm right before the 13D filing, strongly suggesting that these other investors are made aware of the interest in the stock. This result does not hold for clients that are less-lucrative sources of commissions for the brokers. Such clients tend to sell the target stock in the days preceding the 13-D filing, suggesting that they were not informed about the activist’s trading activity.
These results raise the question of why an informed asset manager should be willing to give up part of its informational advantage by trading with brokers that tend to leak to other market participants. One potential answer relies on the repeated nature of the trading relationship between brokers and asset managers. Consistent with this hypothesis, we find that being an informed trader in the past predicts being a follower in the future, suggesting that informed investors might actually form a ‘club’ in which information is shared and in which the brokers enforce respect for the rules. Simple computations reveal that the economic gains for joining the club in terms of future tips exceed the expected losses from competition from other club members. Hence, joining the club is a rational choice for asset managers.
The complete article is available for download here.
