Roy Zuckerman: Synchronized Arbitrage and the Value of Public Announcements
July 22, 2012
Hedge fund managers frequently announce positions they are taking in stocks, whether short or long, and offer a public rationale for their actions. Why do they do this? In this paper, I empirically investigate one prominent explanation for these announcements, namely that they serve as a public synchronizing signal for arbitrageurs.
Abreu and Brunnermeier (2002) discuss this notion of synchronized arbitrage. They hypothesize that a single arbitrageur is incapable or unwilling to correct a large mispricing, and that a coordinated action by a critical proportion of arbitrageurs is required. Abreau and Brunnermeier further claim that in this setting, arbitraguers face a synchronization risk, derived from their uncertainty about the time at which other arbitrageurs will act on a commonly known mispricing. Under these assumptions, a rational arbitrageur will act on the mispricing only if he believes that a critical proportion of arbitrageurs will follow him in a timely manner.
Abreu and Brunnermeier add that arbitrageurs can minimize synchronization risk by publicly announcing the mispricing. An arbitrageur’s announcement could make the mispricing commonly known, signaling to other arbitrageurs to act upon it. If successful, the announcement would trigger action by a cascade of arbitrageurs and result in large positively autocorrelated returns in the underlying security. However, in order to be effective, the announcement must be credible, as traders have a significant incentive to manipulate short-term prices. The manipulation hypothesis is discussed in Benabou and Laroque (1992) who show that even if traders care about their reputation, the incentive to manipulate through public announcements remains significant. If this is correct, the data may show a short-term price spike, but no long-term abnormal performance.
I test the synchronization hypothesis in this paper. To do this, I scan media outlets for public announcements made by hedge fund managers between January 2000 and December 2008. In these announcements, managers identify the arbitrage opportunity and share their reasoning for why the asset is mispriced. Perhaps the most well known examples of such announcements involve George Soros’ attacks on the British Pound in 1992 and on Asian currencies in 1997. More recent announcements include James Chanos’ revelations regarding Enron’s accounting practices in October 2000 and David Einhorn’s analysis of Lehman Brothers’ sub-prime positions in 2008.
Consistent with the notion that large arbitrage opportunities require coordination of a large numbers of arbitrageurs, I find that managers target, almost exclusively, large firms. I find that firms identified by managers as being overvalued significantly underperform the relevant benchmarks. The effect of announcements is both immediate and long lived. On the first day after a short-event, affected firms have abnormal returns of approximately 250 basis points while over longer horizons, of up to 24 months subsequent to the public announcement, average returns range from 324 to 376 basis points per month, lower than the relevant benchmarks. Negative returns are extremely persistent across time and do not reverse over longer horizons. In fact, more than a third of event firms file for bankruptcy or are delisted from major exchanges during this period of time.
On the other hand, firms identified by managers as undervalued have abnormal returns of approximately 170 basis points on the first post-event day, but this return quickly reverses, and buyers of long-event firms do not earn any abnormal returns over longer horizons. I find support for the hypothesis that public announcements serve as a synchronizing signal by examining post-announcement short selling volume and changes in funds’ derivative positions. I obtain daily lending contract data from a major private lender and show that for firms identified as overvalued, the number of shorted contracts increases dramatically after the public announcement by the manager.