Hedge funds have to disclose their long holdings in public companies every three months but from time to time they may ask for exceptions. Until the request is denied (or the approved period of confidentiality expires), they are allowed to hide those holdings from the public’s prying eyes. Hedge funds usually do this to fully establish their positions in a stock. Last year Warren Buffett asked for confidentiality for his IBM positions and thanks to the approval of his request he was able to amass a $13 billion position in the stock.
Why do hedge funds hide some of their new positions but not other new positions? Do they have an information advantage in those stocks that they seek to hide? Georgia State University professors Vikas Agarwal, Yuehua Tang, and Baozhong Yang, and Wei Jiang from Columbia University have an upcoming Journal of Finance paper titled “Uncovering Hedge Fund Skill from the Portfolio Holdings They Hide”. Here is the abstract of the paper:
This paper studies the “confidential holdings” of institutional investors, especially hedge funds, where the quarter-end equity holdings are disclosed with a delay through amendments to the Form 13F and are usually excluded from the standard databases. Funds managing large risky portfolios with non-conventional strategies seek confidentiality more frequently. Stocks in these holdings are disproportionately associated with information-sensitive events or share characteristics indicating greater information asymmetry. Confidential holdings exhibit superior performance up to twelve months, and tend to take longer to build. Together the evidence supports private information and the associated price impact as the dominant motives for confidentiality.
The researchers note that “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”. They found that hedge funds’ confidential holdings outperform their regular holdings anywhere from 5.2% to 7.5% over a 12-month period. Hedge funds’ confidential positions are about three times as large as their other positions, so they make sure that they took advantage of their information advantage by building larger positions.
Agarwal et al describe the approval process as follows:
Given the perceived benefits of seeking confidentiality, it is necessary to discuss the associated costs. Gaining confidential treatment is not meant to be a trivial task and is not guaranteed.2 The applying institution must provide a sufficient factual basis for the objection to public disclosure, including a detailed position-by-position description of the manager’s investment strategy (e.g., risk arbitrage), along with supporting analysis that public disclosure of the securities would reveal the investment strategy and harm the manager’s competitive position. If denied (which usually takes two to twelve months during our sample period), the institution is obligated to file an amendment disclosing all the confidential positions immediately (within six business days).
Overall, this study shows that hedge funds’ “regular” stock picks have positive abnormal returns but their “confidential” stock picks have even better returns, outperforming their regular picks by 5-7 percentage points. Insider Monkey will start giving more frequent and timely updates regarding hedge funds’ confidential stock picks. Stay tuned.