Do Hedge Funds Profit From Mutual-Fund Distress?
[report]
Joseph Chen, Samuel Hanson, Harrison Hong, Jeremy Stein
2008
unpublished
This paper explores the question of whether hedge funds engage in frontrunning strategies that exploit the predictable trades of others. One potential opportunity for front-running arises when distressed mutual funds-those suffering large outflows of assets under management-are forced to sell stocks they own. We document two pieces of evidence that are consistent with hedge funds taking advantage of this opportunity. First, in the time series, the average returns of long/short equity hedge
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... are significantly higher in those months when a larger fraction of the mutual-fund sector is in distress. Second, at the individualstock level, short interest rises in advance of sales by distressed mutual funds. We are grateful for helpful feedback from Robin Greenwood, Jeff Kubik, Andrei Shleifer, Erik Stafford, seminar participants at the Federal Reserve Bank of New York and the Yale School of Management, and students in Stein's Economics 1760 and 2728 classes. I. Introduction Consider an arbitrageur who learns that a big investor is about to sell a large amount of a particular stock, and who understands that this sale is likely to have a significant price impact. How might the arbitrageur take advantage of this knowledge? Broadly speaking, there are two types of trading strategies available to him. The first strategy, "liquidity provision", involves the arbitrageur buying the stock after the big investor has sold it and knocked down the price, and then holding as the price reverts towards its pre-sale value. The second strategy, "frontrunning", involves the arbitrageur shorting the stock before the big investor has had a chance to sell it, and then covering this short position immediately after the sale occurs. While liquidity provision is undoubtedly a socially desirable activity, front-running is more controversial. Indeed, the potentially adverse consequences of front-running have been repeatedly pointed out by academics, practitioners and policymakers. DeLong et al (1990) demonstrate that front-running, while individually rational for the arbitrageurs who profit from it, can nevertheless push prices further away from fundamentals and increase volatility. Brunnermeier and Pedersen (2005) offer a similar analysis of what they call "predatory trading", and present several anecdotal accounts of cases where such activity appears to have played an important role. Perhaps the best-known of these stories comes from the meltdown of Long Term Capital Management (LTCM) in the fall of 1998; it is widely believed that LTCM's initial troubles were magnified by the actions of front-runners. Whatever its implications for market efficiency, it should be noted that there is nothing illegal about front-running. The information that allows arbitrageurs to predict the trades of other investors may well come from public sources. 1 This is not to say that there are not also 1 To take one possibility, it may be that certain high-frequency statistical arbitrage strategies are profitable in part because they succeed in forecasting imminent order flow.
doi:10.3386/w13786
fatcat:vao4updzhva5lgls3tk6guo5fu