An article in Social Science Research Network on July 24th was designed to test the hypothesis that “hedge fund managers gain an informational advantage in securities trading through their connections with lobbyists.” Not surprisingly researchers Meng Gao (National University of Singapore, RMI) and Jiekun Huang (University of Illinois at Urbana-Champaign – Department of Finance) found that the transmission of private political information in the financial markets did occur on a regular basis and that the information was valuable to the managers of hedge funds.
Interestingly, Gao and Huang note the political outperformance of connected funds decreased significantly after the STOCK Act became law in April of 2012.
Politics, business and hedge funds
The article begins by emphasizing the fact that government policies have a huge influence on companies and and stock prices today. A 2013 Duke University/CFO Magazine Business Outlook Survey pointed out that federal government policies rank second on the list of the top three external concerns corporations face, following consumer demand.
The authors also highlight that lobbyists — who have access to private political information because they routinely exchange information with legislators and many are themselves former legislators — are a primary source of information for hedge fund managers. A 2006 Wall Street Journal article reports that Washington is a “gold mine of market-moving information” for hedge funds. The article said that hedge funds hire lobbyists not just to influence decision-makers, but to get access to valuable information about ongoing or impending actions by the government.
Gao and Huang point to anomalous trading in USG Corporation (NYSE:USG) as an example of transmission of valuable political information.
Back in late 2005, USG Corp. was looking at $5.5 billion in lawsuits for asbestos-related injuries and some analysts were even doubting the company’s future. Yet on November 15, 2005, the USG was up more than 5% on triple the usual trading volume even though there was no company-specific news. However, the next day, the Senate announced a plan to create a $140 billion bailout fund to assist firms such as USG Corp. with their asbestos liabilities. The market somehow reacted before the public announcement, which led to speculation by the financial media that some investors made trades based on information from political consultants.
Study methods and results
The study uses a large dataset on long-equity holdings of hedge funds from 1998 to 2012 as well as a database of federal lobbying expenditures to identify potential information transfers from lobbyists to hedge funds. The idea here is that hedge funds gain an informational advantage by their connections with lobbyists, so therefore connected hedge funds should trade more actively in stocks that are sensitive to political decisions than non-connected funds. By the same token, connected hedge funds should also outperform non-connected hedge funds on their politically sensitive holdings. Gao and Huang call this the information transfer hypothesis.
The evidence confirms that connected hedge funds produced higher returns on their political holdings. The authors summarize the results. “A strategy of buying a mimicking portfolio of political holdings by connected funds delivers an abnormal return of 63 to 86 basis points per month, which suggests that connected funds possess an informational advantage in trading politically sensitive stocks.”
Gao and Huang also created a spread portfolio using a difference in-differences analysis.This showed that connected funds yield a return of 78 to 81 basis points greater per month on their political positions than on non-political ones compared to non-connected funds. This illustrates that the better performance of connected funds on political holdings is not driven by superior stock picking or by political stocks generally delivering higher returns.
Finally, one interesting paragraph in the study specifically discusses Jim Chanos. The authors state:
Besides portfolio optimization considerations, the observed “underallocation” may be due to unobserved actions. Specifically, connected funds may strategically time their trades around disclosure dates to avoid revealing their information to competitors (Kacperczyk, Sialm, and Zheng 2008). For instance, in his interview on CNBC, James Chanos, a hedge fund manager, stated that “if (a 13F position of another hedge fund) overlaps with one of our longs or shorts, sure my trade desk will tag it to me or head of research.” Using trade-level data, Wang (2012) shows that portfolio managers are more likely to initiate new trades at the start, rather than at the end, of a quarter and that these start-of-the-quarter trades outperform end-of-the-quarter ones. This suggests that our measures based on the disclosed quarter-end positions may underestimate the true level of connected funds trading and holdings in political stocks. Unfortunately, because of data limitations, we are unable to gauge the magnitude of the underestimation for our sample of hedge funds.