Hedge Funds to Analysts: Wink Once for Buy, Twice for Sell

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There is a certain art to the practice, common on Wall Street, of getting away with an ethically sketchy activity that, while perhaps technically not against the law, would look horrible if exposed to public view.

One of the rules about finding a new way to front-run the market, for example, is that you don't just come out and say, "This thing that we're doing will let us gather non-public information and then front-run the market. Nifty, isn't it?" Especially not in writing. Especially, especially not if that writing could make its way into the hands of New York Times reporter/columnist Gretchen Morgenson.

That, of course, is exactly what happened to two hedge funds owned by the investment giant BlackRock.

The BlackRock hedge funds, as well as other firms – including British hedge fund Marshall Wace and Two Sigma Investments, a U.S.-based firm – came up with a practice whereby they would circulate questionnaires to brokerage analysts who covered certain stocks, and whose opinions often moved the prices of those stocks when made public, Morgenson reports. The questionnaires, which were filled out weeks or months before the analysts went public with their recommendations, asked them questions like "This company you cover, how do you feel about their profits?" and "What are the chances they'll be bought out?"

The hedge funds would read between the lines of the analysts' answers, then trade on that close-reading.

This little informational head start is known as a "front-run," which is exactly how BlackRock employees described the analyst Q&A practice in confidential memos.

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 revisions.”

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’ recommendations.

A BlackRock spokesman was forced to apologize for the contents of that memo, calling it "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."

It may, in fact, be legal to send analysts probing surveys ahead of their public pronouncements. Analysts aren't typically privy to inside information about companies they cover (and they're often wrong) so trading on what a tech analyst thinks of Apple is a lot like making InTrade bets based on whether or not Bill Simmons thinks the Knicks will let Jeremy Lin leave.

But bragging about "front-running" in your internal memo is just asking for trouble. And in a summer with Libor, the London Whale, PFGBest, and mortgage bias settlements, more trouble is the last thing Wall Street needs.