Do Institutional Investors Have an Ace up Their Sleeve?

The SEC’s confidential disclosure exceptions provide a good balance between transparency and protecting the trade secrets of institutional investors.
September 24, 2010
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Secrecy is to hedge funds what secret sauce once was to Jack-in-the-Box: fund managers argue that the ingredients and precise amounts that make up their investment portfolios are intellectual property that, if publicly disclosed, would allow competitors to replicate their successes.

Hedge funds are exempt from most SEC disclosure rules for investment companies because they are not marketed to the general public and only certain qualified investors are permitted to invest in them. Until, that is, such funds reach $100 million or more in publicly traded equity, when disclosure requirements under section 13(f) of the Securities Exchange Act of 1934 kick in. Some hedge funds deliberately keep publicly traded equity holdings below the $100 million mark to avoid disclosure. But successful funds have a tendency to grow, and most inevitably surpass the $100 million baseline.

But the SEC has acknowledged that large institutional investors have grounds for keeping part of their portfolios secret. In 1978, the regulator created an exception to the 13(f) requirement, allowing funds to request that certain sensitive portions of their holdings be disclosed to the SEC but only to the general public at a significant delay (usually one year). Large funds are able to employ this exception when their positions qualify as so-called unfinished acquisition or dispositions and unfinished risk arbitrages. For example, a hedge fund may spread out a purchase of 100,000 shares of a publicly traded firm over several weeks that happen to fall on either side of the quarterly reporting deadline, and wouldn’t want to tip its hand by disclosing the transaction in progress.

Confidentiality is maintained throughout the SEC’s review and ruling, which can take two or three months; in essence a fund enjoys the benefits of confidentiality even if its request is ultimately rejected. Further, the rule is not entirely objective about what qualifies as a confidential holding. As a result, Professor Wei Jiang says, more funds apply for confidential rulings than are qualified. “The rejection rate of 20 percent suggests that too many firms may be seeking 13(f) confidentiality protection,” she says.

Some funds have aggressively — and often dubiously — sought the confidentiality protection. When D. E. Shaw, one of the top ten hedge funds, issued a blank 13(f) in August 2007, claiming that its entire portfolio of publicly traded equity should remain secret, the SEC rightfully rejected the claim. At other times, the use of confidentiality by the largest funds, whose trading decisions can have disproportionate effects on the market, has prompted unintended consequences. That’s what happened in 1997 when Berkshire Hathaway masked its holdings in Wells Fargo in its quarter-end filing by resorting to confidentiality. Because the public portion of Berkshire Hathaway’s 13(f) did not reflect the fund’s well-known 8 percent stake, the market read the absence as Berkshire Hathaway’s having sold off its holdings in the bank. In the hour after the 13(f) was released, Wells Fargo’s stock price plunged almost 6 percent, and the bank lost approximately $5 billion in a matter of hours, much (but not all) of which was regained only after Wells Fargo confirmed that Berkshire Hathaway’s holdings in the bank remained more or less unchanged.

“These are extreme examples, but they illustrate concerns about aggressive and unchecked use of 13(f) exceptions,” says Jiang, who conducted the first comprehensive study of how 13(f) confidentiality filings are used by institutional investors.

To learn what motivates confidential holdings, and whether they perform better or worse than public holdings from the same fund, Jiang worked with Vikas Agarwal, Yuehua Tang, and Baozhong Yang of Georgia State University, using data from the SEC’s Electronic Data-Gathering, Analysis, and Retrieval (EDGAR) database to piece together the confidential filings of large institutional investors between 1999 and 2007.

The researchers first looked at the frequency and distribution of exception filings — did most funds file intermittent exceptions, or did some file at regular intervals while others filed only rarely? The researchers found that the top 10 filers requesting confidentiality exceptions accounted for more than 40 percent of all confidential filings; of these, nine were hedge funds.

When the researchers looked at the characteristics of these heavy users and their confidential holdings, what they found suggested that fund managers are motivated primarily by the desire to keep their special mix of holdings secret, and by extension, to keep the strategies they use to achieve that mix secret. The heaviest users of the 13(f) exception were the least diversified, riskiest, and largest funds, and had the highest portfolio turnover, suggesting highly active fund management. On the whole, these funds’ confidential holdings were much more subject to information asymmetry than the publicly disclosed holdings — they were stocks about which a small group of people knew much more than the general public. These stocks tended to be smaller, less liquid, less likely to be tracked by analysts, more subject to stress risk, and more subject to corporate events like mergers and acquisitions.

When the researchers compared the performance of the confidential portion of holdings with those that were made public, they found that, adjusted for risk, the confidential holdings outperformed public holdings significantly, by 5 to 7 percent annually. This suggests there really is a return due to the active management strategies employed by these funds. “Investors,” Jiang says, “should take comfort in the outsize returns on confidential holdings as evidence that the fees charged by these active fund managers may be justified.”

Analysts looking to assess more than general institutional ownership, like tracking holdings after significant events like mergers at particular institutions, would be well served by knowing that the 13(f) may not reveal a complete picture of holdings, with the 1997 Berkshire Hathaway filing a case in point.

Despite the somewhat high rate of confidential filings, overall, the 13(f) exception works well as a regulatory tool, Jiang says. “It provides the public some transparency — a CEO obviously wants to know who the shareholders are, who other traders are, and what their trading propensities are. At the same time, the exemption rules appear to provide institutional investors adequate relief to protect sensitive proprietary information.”

Wei Jiang is associate professor of finance and economics and a senior scholar at the Jerome A. Chazen Institute of International Business at Columbia Business School.

Wei Jiang

Wei Jiang is Arthur F. Burns Professor of Free and Competitive Enterprise in the Finance and Economics Division, and the Vice Dean (for Curriculum and Instruction) at Columbia Business School.  She is also a Scholar-in-Residence at Columbia Law School, a Senior Fellow at the Program on Corporate Governance at Harvard Law School, and a Research Associate of the NBER—Law...

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