Are Top Hedge Funds Getting A Signal on Earnings Revisions?

Some of Wall Street’s largest brokerage houses are allegedly giving a few of their top hedge fund clients an early indication of their research analysts’ sentiments about the companies they follow, enabling these clients to trade ahead of other investors.

According to today's New York Times, top hedge funds are sending questionnaires that analysts at these brokerage firms answer and submit electronically, either monthly or quarterly. This could signal whether the analyst plans to revise its earnings estimates or upgrade or downgrade a stock.

One of the key questions asked of analysts is about possible earnings surprised at companies, they follow, wrote Gretchen Morgenson, in an investigative piece, "Surveys Give Big Investors an Early View from Analysts."

Major buy side firms including hedge funds run by BlackRock; Marshall Wace, a British hedge fund manager, and Two Sigma Investments, a United States hedge fund company, are using these types of questionnaires completed by analysts to gauge their thinking on the prospects of particular stocks they cover.

Because these hedge funds generate huge commissions, Wall Street firms are feeling the pressure to please them. Firms such as Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch and UBS have participated in these survey programs, the New York Times reports.

The hedge funds, in turn, feed the analysts’ answers into their trading algorithms, "determining which stocks to buy or sell," said the article.

So much for a level playing field on Wall Street!

While earnings upgrades and downgrades can make a stock soar or plunge, sharing this information ahead of the disclosure date is supposed to be illegal. But new recommendations from sell-side research analysts to buy or sell a stock, can produce huge returns.

Recently, the Facebook IPO on Friday May 18 met with a big sell off on the following Monday, supposedly because sell-side analysts warned their top clients about a change in their outlook for the social networking company. However, Facebook was not an isolated incident.

According to documents examined by the New York times, "the hedge fund practice of trawling for analysts’ shifting views is systematic and growing on Wall Street."

BlackRock Scientific Active Equity, an asset management firm that was part of Barclays Global Investors before it became part of BlackRock in 2009, is one of the leading participants in these surveys. While the BlackRock surveys are careful to ask that analysts only supply the views they have already stated publicly, in other confidential documents describing the surveys, company officials say that nonpublic information is what they are after.

Documents reportedly showed that in 2007 Barclays Global Investors sent surveys to the firm’s brokers asking them to respond on a scale of 1 to 5 about the expected direction of earnings for a particular company, where 1 signals a significant downward revision and 5 indicates the opposite.

However, in response, a BlackRock spokesman, admits that the language used in the internal memos "is sloppy and inaccurate and totally inconsistent with the firm's high ethical standards."

"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 information."

But BlackRock’s spokesman, continuing with his statement, explains this is all part of a quantitative approach to investing.

"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 investment decisions."

Several officials for Citigroup, UBS and JP Morgan Chase responded to the New York Times, emphasizing that they had strict policies in place for participating in client surveys, requiring that analyst comments were consistent with their publicly held views.

Nevertheless, this sounds like a difficult line to walk for compliance officers at sell side firms, and it’s one more example why investors, not privy to such surveys or earnings surprise signals, may question the fairness of Wall Street.