Why Do Hedge Funds Avoid Disclosure? Evidence from Confidential 13F FilingsVW Staff
A basic challenge facing hedge fund industry participants and regulators is determining the extent to which the composition and performance of investment portfolios should be publicly disclosed. Increased portfolio disclosure, and the associated increased transparency, is considered beneficial to the extent that it allows investors to make more informed investment allocation decisions and reduces potential agency costs that can arise when managerial actions are more opaque.
Increased transparency, however, comes at a cost if it reveals proprietary information that allows competitors to free-ride on a fund manager’s efforts to identify profitable investments and trading strategies.1 Increased transparency is also costly when it allows front-runners to trade against a fund that is in the process of accumulating or disposing of a position.
Transparency is costly in these regards, not only because of its negative effect on the disclosing fund’s profits, but also (from a policy perspective) because it reduces fund manager incentives to become informed, thereby harming price discovery. An assessment of the importance of protecting the ability to profit on proprietary information through reduced disclosure is complicated by the fact that such information, by definition, is difficult to identify. In this paper we side-step this issue by examining a sample of 13F filings of hedge fund holdings where fund managers seek confidential treatment by the Securities and Exchange Commission (SEC) of some or all of their portfolio positions.
Hedge fund and other institutional investment managers who exercise investment discretion over $100 million or more in Section 13(f) securities are required to report their quarterly holdings on Form 13F to the SEC within 45 days of each quarter-end. However, managers may request confidential treatment to delay public disclosure of some or all of their holdings. Holdings that are kept confidential at the time of the original 13F confidential treatment filing are eventually released to the public at a later date through a Form 13F “add new holdings” Amendment. The ability to examine the characteristics and stock price performance of these confidential positions allows for a useful laboratory in which to develop a better understanding of the determinants of hedge fund managers’ disclosure decisions and to contribute to the policy debate on optimal hedge fund disclosure.
Our analysis focuses on all Form 13F confidential filings by a sample of 250 hedge fund managers that file Form 13F over the period 1999 to 2006. We find that securities which are kept confidential at the time of the original 13F filing earn positive and significant abnormal returns over the post-filing confidential period; i.e., from the time of the original 13F filing up until the time that the confidential positions are ultimately revealed to the public through a 13F Amendment filing. In contrast, those securities that are disclosed at the time of the original filing do not exhibit abnormal stock price performance over this same time period. A probit analysis finds statistically and economically significant evidence that confidential treatment requests are more likely for individual positions that perform well over the confidential period. These results suggest that hedge funds avoid disclosure to protect valuable proprietary information and thereby highlight a benefit of allowing confidential treatment and less transparency.
In addition to examining how (forward-looking) confidential period returns affect the disclosure decision, we also investigate how past returns (measured over the filing quarter) affect the likelihood of a confidential treatment request. To the extent that hedge fund managers seek to protect profitable ongoing investment strategies, we would expect past returns to be positively associated with the likelihood of seeking confidential treatment. An alternative possibility is that managers seek confidentially in order to strategically hide past losers or “window-dress” their portfolios. Consistent with the proprietary information hypothesis, we find that hedge fund managers are more likely to seek confidential treatment for positions that have performed well in the past. We find no evidence consistent with the use of confidential treatment to hide past losers.
We also investigate the extent to which the liquidity of individual holdings affects the disclosure decision. Hedge funds that are seeking to accumulate or dispose of an illiquid position may seek confidentiality to avoid the costs of being front-run; front-running costs can be potentially severe for illiquid securities due to the larger price impact of advanced trading. In addition, because of concern about price impact, the accumulation and disposition of illiquid positions is done more slowly making it more likely that such activities are ongoing at the time of a 13F filing and thereby making a confidential treatment request more likely. Consistent with these arguments, we find that confidentially held securities are significantly more likely to be illiquid, as measured by Amihud (2002) and by whether the confidential request pertains to less liquid 13(f) -reportable non-equity positions, like equity options and corporate debt.
Finally, we examine whether greater usage of confidential treatment contributes to the success of the advisor’s hedge fund investors. Net-of-fees, we find that portfolio returns are positively related to greater usage of confidential treatment in the prior quarter. Specifically, an increase in the percentage of confidential securities from 0% to 25% is associated with a significant increase in subsequent monthly portfolio returns of about 50 basis points. These results suggest that the gains associated with confidential treatment are at least partly captured by hedge fund investors.
The remainder of the paper is organized as follows. Section 2 describes the data. Section 3 discusses the methodology and empirical results. Section 4 concludes.
A. Form 13F, confidential treatment requests and Form 13F Amendments
We obtain quarterly holdings of hedge fund companies from Form 13F filings on the Edgar website. Since 1978, all institutional investment managers (including hedge fund managers) who exercise investment discretion over accounts holding at least $100 million are required by Section 13(f) of the Exchange Act to make quarterly disclosures of portfolio holdings to the SEC on Form 13F within 45 days of the quarter end.
The types of securities that are required to be reported on Form 13F include exchange traded and NASDAQ-quoted stocks, equity options and warrants, convertible bonds, and shares of closed-end investment companies; short positions, shares of open-end funds, and private securities are not required to be disclosed. All long positions in such securities with more than 10,000 shares or with market values exceeding $200,000 are required to be reported. Form 13F reporting items include the issuers of the securities, the security type, the cusip number, the number of shares, and the market value of each security owned. Managers can report aggregated holdings across different funds managed by the same management company.
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