How Do Hedge Funds Hide Information From The Public?
13F filings provide a view into what the smartest and most capitalized money managers on Wall Street are doing, but they often need to be taken with a grain of salt.
It was a dreary and chilly morning in New York City on October 29th, 1929. It would have been like any other Tuesday on Wall Street except for a torrent of frantic activity on the New York Stock Exchange trading floor, much more so than the usual chaos one would experience. Among the cacophony of shouting traders, one common word that seemingly everyone was shouting was clear: "SELL!"
This day would be a bloodbath for US stocks. In the first three minutes alone, nearly three million shares exchanged hands. This was an extraordinarily high volume for the time. Everyone wanted to sell as soon as possible. The Dow ended the day down almost 12%. This was the worst of several deeply red trading days in October 1929 that collectively became the most devastating stock market crash in US history. This signaled the start of the Great Depression that devastated the US economy and transitively, the livelihoods of millions of Americans.
Crowd of people gather outside the New York Stock Exchange following the Crash of 1929 (Library of Congress)
It was widely believed that irresponsible financial practices and high finance cronyism were largely to blame for this stock market crash, which prompted the Roosevelt administration to sign in to law the Securities Exchange Act of 1934 (SEA 1934). This law introduced sweeping new securities trading regulations and also created the famous/infamous Securities Exchange Commission (SEC).
Another cornerstone effect of SEA 1934 is the creation of Form 13F, as defined in Section 13(f). At a high level, this section of the law requires institutional investment managers with more than $100 million in assets under management (AUM) to report to the SEC, on a quarterly basis, all US equity positions in the manager's portfolio via Form 13F.
It's hoped that 13F filings can provide more transparency into the holdings and activities of the largest funds on Wall Street, thus creating more trust in the US stock market. Over time, 13F filings have become a popular tool for investors to keep track of what large funds (aka "smart money") are doing so they can copy trades or find inspiration for trade ideas. In line with this trend, in recent years there's been a huge proliferation of websites keeping track of and aggregating information from 13F filings such as whalewisdom.com, hedgemind.com, and hedgefollow.com.
However, despite their popularity, 13F filings are often an unreliable or incomplete view into a hedge fund's strategy. Like a theatrical show, 13F filings are what hedge funds present on the stage, which is very different from what takes place behind the proscenium arch. This article dives into two main ways hedge funds work around 13F filings to conceal their strategies and sometimes even mislead the public, to their own benefit.
How Do Hedge Funds Play Hide and Seek With 13F Filings?
The two main ways US hedge funds hide their positions from 13F filings, and thus public scrutiny are:
Positions that don't need to be reported on the 13F, such as shorts and total return swaps
Confidential holdings and 13F restatements
1. Not All Trade Positions Need To Be Reported
A top criticism of 13F filings is that funds are only required to report long positions, options positions, and a couple other asset types not relevant to this article (ADRs and convertible notes). The point being, these requirements are incomplete and leave out important elements of a portfolio, thus allowing funds to publicly present an incomplete and potentially misleading view of their portfolio.
For one, funds don't have to report short positions in 13F filings. This creates a massive blind spot in the state of a fund's portfolio since short positions are extensively used, especially in alpha-focused (market outperformance) funds that often have a massive edge in information access and processing relative to the general public. The acceptable omission of short positions from 13F filings also makes it easier for a fund's portfolio to be misinterpreted. Hedge funds like to hedge their positions (hence the name) and short positions are often accompanied with a long hedge. As such, the long positions shared in a 13F filing could very well just be a hedge for a short position that wasn't shared. Keen 13F observers could misinterpret these long hedge positions as a signal that a fund is bullish on a stock when they are actually bearish.
Another major position type that's not required for 13F reporting are total return swaps. A total return swap is a complex financial contract that essentially allows a fund to benefit from the appreciation of an asset without actually owning it.
In more detail, a bank loans money to a fund but doesn't actually send the money over. Instead the bank uses this money to buy assets chosen by the fund, and receives periodical interest payments from the fund while distributing income generated by the asset as well as capital gains to the fund. In this way, a fund can go long on a stock or ETF without actually owning anything, while the bank receives a fixed rate of payment for the credit risk it takes on (i.e. the asset's price falls but the fund defaults and can't pay the difference).
Remember Archegos? The infamous fund that suddenly capitulated in March 2021 with an unprecedented series of margin calls totalling billions of dollars. The fund seemed to appear out of nowhere (Archegos who?!) and no one seemed to know about its massive stock positions until it was too late. Archegos was able to stay under the radar and hide these positions from public scrutiny via total return swaps which didn't have to be reported in 13F filings.
The leveraged downfall of Archegos (source: Bespoke Investment Group)
It's indisputable that the incomplete reporting requirements of 13F filings allows hedge funds to hide a lot more than is immediately obvious. This is one major reason why 13F filings is an unreliable vehicle to understand money movements in high finance. Sometimes, this also has disastrous consequences, such as the surprising and massive capitulation of Archegos.
2. Confidential Holdings And Oopsies
Two other popular methods hedge funds use to hide their trades from 13F filings are confidential filings and restatements. Both are legal ways with which a fund can delay or omit information in 13F filings.
With confidential filings, a fund can submit a request to the SEC within 45 days of a quarter's end to not share specific portfolio positions in the quarter's 13F filing if the fund can demonstrate that disclosing will harm its competitive edge. According to the SEC, this rule encourages competition in the market and reduces volatility. While the SEC reviews a confidential filing request, the affected positions don't need to appear in the quarter's 13F filing. If approved, nothing needs to be done. If denied, the fund needs to file an amendment within 6 business days that publicly reveals the requested positions.
In the worst case, confidential filing requests allow funds to significantly delay disclosing a position until after the SEC declines the request. In the best case, they don't need to disclose the positions for the full requested period. No wonder hedge funds love to use this. According to a paper published in The Journal of Finance titled "Uncovering Hedge Fund Skill from the Portfolio Holdings They Hide", hedge funds constitute about 30% of all 13F filing institutions yet account for 56% of all confidential filings. In addition, they relegate the largest portion of the portfolio to confidential holdings among these institutions (33% for hedge funds vs 20% for investment companies/advisors and 10% for banks and insurance companies). Finally, the same paper found that, in the data sample they examined, stocks in rejected confidential filing requests outperformed stocks disclosed in the original 13F filing by 6.48% in annualized returns.
Besides confidential filings, hedge funds can claim that they've made mistakes in a previous 13F filing and publicly file an amendment to correct. We'll refer to this type of amendment as a "restatement". Unlike confidential filing amendments, restatements can be done at any time and unsurprisingly, it's more popular with hedge funds. A paper published in SSRN titled "The Strategic Use of 13F Restatements by Hedge Funds" observed in their data sample that hedge funds were more likely to use restatements than confidential filings (3.12% vs 2.08%) and restatements affected a significantly larger portion of a portfolio's total value. Although the paper didn't find significant outperformance of stocks in restatements (0.75% mean annualized Raw Return Gap), this is likely because restatements are more often used for their intended purpose, to correct honest mistakes in 13F filings. However, given the loose regulation around restatements, they are definitely also used to delay the disclosure of important positions in a hedge fund's portfolio under the guise of filing mistakes.
Although 13F confidential filings and restatements are not well known, the findings from the two papers cited above certainly suggest that 13F filings cannot be taken at face value and it's sometimes more important to consider the confidential filings and restatements that come after the original filing. The most valuable information often resides not in what one is immediately willing to share, but in what one is trying to hide.
13F filings provide a view into what the smartest and most capitalized money managers on Wall Street are doing. No wonder it's a popular information source for investors of all sizes. However, these filings need to be taken with a grain of salt. There are many ways for funds to delay or hide information in them, especially for hedge funds employing short- and medium-term strategies. What appears as a bullish position on a 13F filing could in reality be a bearish hedge and vice versa.
In the stock market, a valuable principle to hold is that you always need to rely on your own due diligence, since market participants ferociously hide their own money-making competitive advantages. Information that appears to be offered on a silver platter, such as 13F filings, needs to be double checked and cross referenced.