They are supposed to be
among Wall Street’s most closely guarded secrets: changes in research
analysts’ views, up or down, of a company’s prospects. But some of the
nation’s biggest brokerage firms appear to be giving a handful of top
hedge funds an early peek at these sentiments — allowing them to trade
on the information before other investors get the word.
The signals come from
questionnaires that analysts answer and submit electronically, either
monthly or quarterly, to some of their firms’ largest hedge fund
clients. Chief among the questions posed to the analysts are those
about possible earnings surprises at companies they follow.
What analysts tell
investors about the companies they follow — and when — is central to
the concept of a level playing field on Wall Street. When
disseminated, analyst downgrades and upgrades can make a stock sink or
soar. Getting that information early can be very profitable for
traders. As a result, regulatory rules require brokerage firms to
restrict the information flow from research departments to prevent the
potential for trading ahead of research reports.
Questions about the
selective release of analysts’ views came up when the brokerage firms
charged with selling Facebook’s initial shares were found to have
warned large buyers about some analysts’ doubts regarding the
company’s prospects. That irked many small investors who had not
received the guidance and sustained losses in their Facebook shares.
The Securities and Exchange Commission is investigating these
But documents obtained by
The New York Times indicate that the hedge fund practice of trawling
for analysts’ shifting views is systematic and growing on Wall Street.
Questionnaires completed by analysts that can telegraph their thinking
are being used by hedge funds run by
BlackRock; Marshall Wace, a large British hedge fund company; and
Two Sigma Investments, a United States hedge fund concern.
The funds say they ask
only for public information, but in at least four cases, documents
from Barclays Global Investors, now a unit of BlackRock, state the
goal is to receive nonpublic information. Two documents state that the
surveys allow for front-running analyst recommendations.
To the degree that these
surveys alert select hedge fund clients to future shifts in
researchers’ views or estimates, analyst participation in them may
contradict firms’ policies stating that research is distributed to all
Analysts at many
companies, including Citigroup,
Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase,
Merrill Lynch and UBS, have participated in the programs. The
analysts’ answers are fed into the hedge funds’ trading algorithms,
determining which stocks to buy or sell.
As one of the largest
payers of trading commissions to Wall Street, BlackRock is a client
that brokerage firms want to please to keep those commissions flowing.
For a period during 2008 and 2009, the firms participating in an
expanded survey received cash based on their results.
Active Equity, the money management unit that was part of Barclays
Global Investors before it was bought by BlackRock in 2009, has been a
leader in these surveys. One of the company’s survey questions, titled
“earnings surprise direction,” asks analysts whether a company’s
coming profits “are more likely to surprise on the upside or
downside.” Another asks: “Do you think the current consensus earnings
forecast” for a specified period “will likely move upwards or
A more recent question
involves takeovers: “How likely is it that the company will be taken
over in the next 6 months?”
The BlackRock surveys are
careful to ask that analysts supply only those views that they have
already stated publicly. But in various confidential documents
describing the surveys, company officials state that nonpublic
information is what they are after. “We expect the earnings surprise
direction to be able to capture the information not released to the
market,” stated a confidential BlackRock memo from November 2008,
detailing its analyst surveys of nine brokerage firms in Asia. “The
question may give the clue on the direction of the analyst’s future
A 2009 document on the
firm’s analyst surveys is even more explicit. “We are trying to
front-run recs,” it said, referring to trading ahead of analysts’
James Badenhausen, a
BlackRock spokesman, said, “The language in the Barclays Global
Investors internal memos is sloppy and inaccurate and totally
inconsistent not only with the stated purpose of the survey but also
with the high ethical standards by which BlackRock does business. The
survey explicitly states that it requests only information that
sell-side research analysts have already disseminated publicly and an
analyst cannot even take part in the survey without first clicking a
button to confirm that answers would be based solely on public
He continued in a
statement, “The surveys allow the group to quantify information from
tens of thousands of analyst research reports so they can feed that
data into the computer models used in the group’s investment process.
The data from these online surveys are just one of more than 100
different factors that the group feeds into the models to determine
Mr. Badenhausen declined
to make any other BlackRock executive available for comment.
Citigroup, UBS and JPMorgan Chase said they had strict policies in
place for analysts participating in client surveys requiring that
their comments were consistent with their publicly held views.
Representatives at Credit Suisse, Deutsche Bank, Bank of America and
Goldman Sachs declined to comment.
Lewis D. Lowenfels, an
authority on securities law in New York City, said that while such
analyst surveys might be legal, they could be improper if they were
being used to mask the transfer of nonpublic information. “The firms
have to be meticulously careful about how they monitor and supervise
these interactions,” Mr. Lowenfels said, “because it would be so easy
to cross the line.”
Making sure that ordinary
investors are not duped by bad research or by opinions disseminated
long after big investors have already had a chance to trade on them
has been a concern of regulators in years past, leading to more
rigorous rules about analysts’ compensation and their independence.
The pronouncements of
powerful Wall Street analysts have long been known to move stock
New recommendations to
buy or sell a stock from major brokerage firms produce big initial
2004 study, titled “The Value of Client Access to Analyst
Recommendations” and written by T. Clifton Green, a professor at Emory
University’s business school, confirmed the profit potential.
Responding rapidly to announcements of changes in stock
recommendations gave brokerage firm clients average two-day returns of
1.02 percent and annualized gains of more than 30 percent, the study
Barclays Global Investors
recognized how profitable such information could be. A confidential
internal update from late 2007 describing the company’s European
analyst survey noted that revisions in analyst forecasts were a
crucial driver of returns. “We observe a contemporaneous one-month
correlation between revisions and returns on the order of 15-20
percent over many years and many markets,” the update noted.
Only trouble is, the
report said, the moves run out of steam relatively quickly.
Asking analysts questions
about earnings direction “may allow us to get ahead of revisions,” the
The 1 to 5 Scale
At the time, Barclays had
enlisted six brokerage firms to participate in the analyst survey,
providing coverage of 88 percent of large European companies. Asked to
respond on a scale of 1 to 5, an analyst giving a 1 to a question
about the expected direction of earnings at a particular company
signals a significant downward revision. An answer of 5 indicates the
opposite. A response of 3 is considered neutral, the document said.
The 2007 presentation
identified some of the best returns generated by the program. Many
involved financial stocks that analysts were beginning to view
negatively as the credit crisis deepened. They included Northern Rock,
a British bank that was later nationalized, and Bradford & Bingley, a
regional British bank and mortgage lender also taken over by the
The document shows how
analysts’ responses about Bradford & Bingley not only preceded public
downgrades but also most likely proved profitable for those trading on
them. Surveys compiled on Aug. 31, 2007, generated negative signals,
with an average response of 2 to the earnings questions.
On Sept. 5, not even a
week later, Lehman Brothers downgraded the stock, noting uncertainties
in asset-backed markets and rising financing costs for the bank. The
stock plummeted, and the company was later taken over. Many
shareholders were wiped out.
A more upbeat case study
from the report concerned the Renewable Energy Corporation, a
Norwegian company. In surveys tabulated on May 31, 2007, an analyst
from Credit Suisse responded to earnings outlook questions with 5s,
positive indications. On June 24, Credit Suisse upgraded its earnings
forecast for the company by 7 percent.
A month later, Renewable
Energy announced an 11 percent increase in earnings per share from a
year earlier. Between the day the analyst surveys came in and the
earnings announcement, the company’s shares rose 22 percent.
The predictive nature of
the surveys led Barclays to introduce more subjective questions. These
included queries about management quality, innovation and
competitiveness, according to an April 2008 internal analysis from
research officials in its United States, Australian and European
units. Among the brokerage firms participating in the “softer” surveys
were UBS, Citigroup, Goldman Sachs, Lehman and Merrill Lynch.
“The questions are vague
but collectively give us a good sense of the analyst’s overall
sentiment towards the company,” the report concluded. “We find that
this sentiment manifests itself in future analyst upgrades and in the
Australian case, positive EPS revisions.”
In 2008, a paper prepared
by Barclays researchers for the firm’s European, United States, Japan
and Asian units analyzed the performance of recent surveys. “The
results support prior evidence that our signal enables front-running
individual analyst recommendations,” the report concluded.
One of the first
companies to devise a way to use surveys to generate outsize returns
was Marshall Wace, a large British hedge fund operator. Its program,
known as Trade Optimized Portfolio System, asked for information from
sales traders in addition to analysts.
In 2009, it was capturing
investment ideas from 290 brokerage houses and 1,900 equity sales
representatives, sector specialists, country specialists and
strategists at investment firms around the world, according to a
report from Albourne, an independent analysis firm. A Marshall Wace
spokesman said that currently the firm’s system has 3,000 brokerage
firm sales representatives participating.
At Barclays, conducting a
poll of equity analysts for changes in sentiment was first proposed in
2003 in Australia, where
financial regulation is more relaxed. It was introduced there in
The surveys were being
tested in the United States in 2005 and were expanded to Europe and
Asia in 2007.
Other hedge funds have
created their own surveys. Two Sigma Investments, for example, set up
a system called Portfolio Idea Contribution System that is patterned
after the Marshall Wace program. A Two Sigma spokesman declined to
It is unclear whether
securities regulators in the United States are concerned about these
brokerage firm surveys. A spokesman for the S.E.C. declined to
But regulators in Europe
have discussed the possibility of improprieties. For example, the
British securities regulator, the Financial Services Authority, said
in a 2006 advisory that it had met with firms using these systems and
warned about their potential for transmitting nonpublic information.
An official at the F.S.A.
said last week that he was unaware of any investigations conducted
into the use of surveys to generate outsize returns.
Many hedge funds in
Europe have concluded that the F.S.A. has blessed the programs.
Nevertheless, it is clear that regulators view trading ahead of
analyst changes to be a misuse of nonpublic information. In July 2007,
the Committee of European Securities Regulators said insider
information included “the coming publication of research,
recommendations or suggestions concerning the value of listed
Regulators also take a
dim view of sharing analysts’ changing views with select customers. In
a recent case against Goldman Sachs, the S.E.C.
fined the company $22 million for allowing select clients to have
private meetings with analysts. The S.E.C. did not charge the company
with tipping the customers improperly but cited the potential for
analysts’ changing views to be misused.
Other regulators are
scrutinizing how brokerage firm research is distributed. The Financial
Industry Regulatory Authority proposed an extensive new rule covering
equity research reports in late 2008. The rule says firms must have
“procedures reasonably designed to ensure that a research report is
not distributed selectively to internal trading personnel or a
particular customer or class of customers.” But the rule has not been
put into place. After receiving comments, the authority has decided to
broaden the proposal to cover debt securities. A new version is
expected later this year.
Firms that selectively
share their analysts’ research could add to unease about fairness on
Wall Street, said Michael Clement, a professor of accounting at the
University of Texas, Austin, who has a background in banking. “As
investors’ portfolios become more global, investors will seek
opportunities where they believe the playing field is level,” he said.
“Analysts’ surveys open the door to potential problems because firms
could start communicating things to some clients that they are not
communicating to all of them. And that’s wrong.”