A topic Sui Chuan and I constantly have a dilemma on would be the confidentiality vs transparency. Should we disclose our holdings to the public? The need for confidentiality is that there is significant downside in telegraphing our methods and trade secrets that will ultimately hamper our ability to act discretely and quickly. Yet on the other hand, with transparency, it can improve market efficiency in the sense of helping others discover undervalued gems. A good article that discusses the merits of sharing such cheap, under-followed stocks is as discussed by blogger O-tone (LINK). While myself, I shall share a paper that studied the ‘confidential holdings’ of institutional investors, especially hedge funds (LINK).
- Hedge funds with characteristics associated with more active portfolio management, such as those managing large and concentrated portfolios, and adopting non-standard investment strategies (i.e., higher idiosyncratic risk), are more likely to request confidentiality.
- The confidential holdings are more likely to consist of stocks associated with information-sensitive events such as mergers and acquisitions, and stocks subject to greater information asymmetry, i.e., those with smaller market capitalization and fewer analysts following.
- Confidential holdings of hedge funds exhibit significantly higher abnormal performance compared to their original holdings for different horizons ranging from 2 months to 12 months. For example, the difference over the 12-month horizon ranges from 5.2% to 7.5% on an annualized basis.
From the research, it has shown that there is a connection between confidentiality and performance. With confidential treatment, it allows hedge funds to accumulate larger positions in stocks, and to spread the trades over a longer period of time; such a relief benefits both informed and liquidity-motivated trading. I do see the merit on this point as often with a larger asset base to accumulate the small and mid-cap stocks, it can span days or weeks. We see that even Buffett requests for confidential treatment regarding his larger investments.
Another point on confidentiality that is irrelevant to outperformance would be that fund managers are paid a management fee and/or performance fee by investors/shareholders. If fund manager’s positions are disclosed every quarterly or so, it would defeat the purpose of this incentive fee as by tracking the quarterly positions, one may not do as badly especially given a value investing methodology.