Do Hedge Funds Manipulate Stock Prices?

• DOI: http://doi.org/10.1111/jofi.12062
• Author: ITZHAK BEN‐DAVID,RABIH MOUSSAWI,AUGUSTIN LANDIER,FRANCESCO FRANZONI
• Date: 01 December 2013
• Published date: 01 December 2013

THE JOURNAL OF FINANCE •VOL. LXVIII, NO. 6 •DECEMBER 2013

Do Hedge Funds Manipulate Stock Prices?

ITZHAK BEN-DAVID, FRANCESCO FRANZONI, AUGUSTIN LANDIER,

and RABIH MOUSSAWI∗

ABSTRACT

We provide evidence suggesting that some hedge funds manipulate stock prices on

critical reporting dates. Stocks in the top quartile of hedge fund holdings exhibit

abnormal returns of 0.30% on the last day of the quarter and a reversal of 0.25% on

the following day.A significant part of the return is earned during the last minutes of

trading. Analysis of intraday volume and order imbalance provides further evidence

consistent with manipulation. These patterns are stronger for funds that have higher

incentives to improve their ranking relative to their peers.

“If I were long and I would like to make things a little bit more rosy, I’d

go in and take a bunch of stocks and make sure that they are higher.. . .

A hedge fund needs to do a lot to save itself.”

Jim Cramer, ex-hedge fund manager, in an interview with

TheStreet.com, December 2006

IN A CONVENTIONAL DESCRIPTION of financial markets, arbitrageurs are consid-

ered a stabilizing force that absorbs nonfundamental shocks and keeps prices

close to fundamental values. Recent research, however, challenges this view

by pointing out that institutional investors can be constrained by agency fric-

tions. These institutional frictions can be the very source of nonfundamental

demand shocks (see Shleifer and Vishny (1997) and Gromb and Vayanos (2010)

for a survey). One dimension of institutional constraints on arbitrageurs’ ac-

tivity arises from their incentives to attract funds and the competition with

other financial intermediaries for investors’ assets. Consistent with this view,

∗Ben-David is with the Fisher College of Business, The Ohio State University,and NBER; Fran-

zoni is with the University of Lugano and the Swiss Finance Institute; Landier is with the Toulouse

School of Economics; and Moussawi is with Wharton Research Data Services, The Wharton School,

University of Pennsylvania. We appreciate the detailed comments of an anonymous referee and of

Jennifer Conrad (Acting Editor). We also thank Alessandro Beber, Bruno Biais, Michael Halling,

YeeJin Jang, Gulten Mero, Tarun Ramadorai, Matti Suominen, David Thesmar, Jason Zweig, and

conference and seminar participants of the 3rd Annual Hedge Funds Conference in Paris, Catolica

University in Lisbon, and the Helsinki Finance Summit for helpful comments. Ben-David acknowl-

edges financial support from the Neil Klatskin Chair in Finance and Real Estate, and from the

Dice Center at the Fisher College of Business. Landier acknowledges financial support from Scor

Chair at Foundation Jean-Jacques Laffont and from the European Research Council under the

European Community’s Seventh Framework Programme (FP7/2007-2013) Grant Agreement no.

312503 - SolSys.

DOI: 10.1111/jofi.12062

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2384 The Journal of Finance R

Zweig (1999) and Carhart et al. (2002) find that mutual funds pump the prices

of the stocks they hold prior to quarterly reporting dates. Blocher, Engelberg,

and Reed (2010) show that short-sellers exercise selling pressure in the last

minutes of the year to inflate their returns.

Here, we focus on the prototypical arbitrageurs—hedge funds—and ask

whether their incentive to attract and retain capital can lead them to distort

stock prices. We present a collection of facts that suggest some hedge funds

pump up the end-of-month prices of the stocks in their portfolios to improve

their reported returns. The literature provides mounting evidence that some

institutions in the hedge fund sector manipulate their reported performance

(e.g., Bollen and Pool (2009), Agarwal, Daniel, and Naik (2011)). The incre-

mental contribution of this paper is to argue that these activities can have a

significant impact on market prices.

The first goal of the paper is to study whether the distortions in asset man-

agers’ trading behavior originating from agency conflicts can systematically

affect asset prices. Second, from a more practical perspective, we wish to con-

tribute to the recent regulatory debate concerning hedge funds. For exam-

ple, the Dodd-Frank Act requires hedge fund registration and more exten-

sive disclosure about assets and leverage. The practice of portfolio pumping

that we explore in this paper does not involve misreporting or misvaluation

of the portfolio holdings. As such, it is not likely to be detected by the reg-

ulator or an external auditor, unless it is systematically searched for using

the appropriate statistical methodology. This paper, along with prior work

on hedge fund manipulation (e.g., Bollen and Pool (2009), Agarwal, Daniel,

and Naik (2011)), contributes to developing the machinery of manipulation

detection.

The study has two parts. First, based on 2000 to 2010 quarterly 13F hold-

ings data of hedge fund management companies that we match to daily and

intraday stock prices, we document that stocks held by hedge funds experience,

on average, large abnormal returns on the last trading day of the month. This

effect is statistically and economically significant: stocks at the top quartile of

hedge fund ownership earn, on average, an abnormal return of 0.30% on the

last day of the quarter, most of which reverts the next day. This effect is similar

in magnitude to the 0.25% end-of-quarter manipulation by mutual funds doc-

umented by Carhart et al. (2002). Moreover, about half of the average increase

in the prices of stocks owned by hedge funds takes place in the last 20 minutes

of trading and reverts in the first 10 minutes of trading on the following day.

The effect exists at the monthly level, although our precision is lower at this

frequency due to the quarterly measurement of hedge fund ownership. In the

cross-section, we find evidence that this price pattern is concentrated in illiq-

uid stocks, consistent with the idea that manipulators focus on stocks on which

they can have larger price impact.1

1We wish to clarify from the start that the observational unit in our data set is a hedge fund

management company. 13F filings provide asset holdings at the management company level or at

the adviser entity level. Each company/adviser reports consolidated holdings for all the funds that

Do Hedge Funds Manipulate Stock Prices? 2385

Moving beyond prices to study trading volume, we focus on trading activity

patterns around the turn of the quarter for stocks owned by hedge funds. We

show that stocks with high hedge fund ownership experience a surge in buying

pressure in the last two hours of the quarter and strong selling pressure during

the first day of the following quarter. Also, we find that these stocks exhibit

abnormally high turnover during the last hours of the last day of the quarter

and during the first hours of the first day of the following quarter. Drawing

on prior research that identifies institutional trades by their large size (e.g.,

Campbell, Ramadorai, and Schwartz (2009)), we show that stocks with high

hedge fund ownership display a stronger intensity of institutional buy trades in

the last 10 minutes of the last day of the quarter than they do on the neighboring

days in the same time interval. Consistent with the manipulation hypothesis,

we do not find a symmetric result for institutional sales of these stocks.

In the second part of the paper, we present evidence linking stock price

patterns that are consistent with manipulation of hedge funds’ incentives to

improve their reported returns. To this end, we match the 13F data to TASS

by aggregating the fund-level variables in TASS at the management company

level. As a proxy for this pattern of manipulation activity, we use the return

difference between the last day of the quarter and the following day on the

management company’s long equity portfolio. We label this quantity the “blip.”

This blip is more pronounced for management companies with concentrated

portfolios, which is consistent with greater “bang for the buck” from manipu-

lation when there are only a few stocks in the portfolio. In addition, we find

that high-blip companies rank at the top in terms of year-to-date performance.

This result is consistent with the evidence in Carhart et al. (2002) that the

mutual funds that appear to manipulate stock prices are those with the best

past performance. The authors argue that, given a convex flow-performance

relation for mutual funds (Ippolito (1992), Sirri and Tufano (1998)), the best

performers have the strongest incentive to manipulate. Further, hedge fund

management companies that had a poor month in terms of total returns are

also more likely to have a high blip, which is probably related to their incentive

to avoid reporting very low returns to their investors. Somewhat related to

this incentive, we show that the discontinuity of hedge fund returns around

zero, first pointed out by Bollen and Pool (2009), is significantly stronger for

management companies with a high blip. This suggests that the evidence that

we present partly explains the evidence in Bollen and Pool’s (2009) paper. A

complementary interpretation is that management companies that misbehave

on one front are likely to do so on other fronts as well, possibly as a result

of poor internal control systems. Also consistent with a “genetic” tendency to

misbehave, we detect persistence in hedge fund companies’ blips, that is, com-

panies that had a high blip in past quarters are more likely to have another

blip in the future.

it has under management. When we use the wording “hedge funds,” we broadly refer to the firms

that belong to this asset class rather than to the specific funds within a management company.