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Do Hedge Funds Manipulate Stock Prices

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Predrag Shipov
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Do Hedge Funds Manipulate Stock Prices
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Hedge funds have an aura of controversy around them that is unparalleled with any other financial institution on the market. Large hedge funds that manage tens of billions of investment capital can have an influence on stock prices due to their sheer size and trading volume. In the past, they manipulated both stocks and the market with serious consequences on the global level. So, the right question is not do hedge funds manipulate stock prices but how they do it.

Hedge funds can manipulate stock prices in several ways, including short selling, pump and dump, and wash trading, among other techniques. At their core is to create an illusion that the trading volume is higher than it is, to create a false narrative about the stock. Some instances demand hedge funds to act as a market maker giving them space to inflate prices.

Before placing their capital on the market, investors need to inform themselves and learn how to avoid these pitfalls. Through the remainder of the article, we will go through all the major market manipulation approaches and what investors can do to shield away from those influences.

Key Takeaways

  • The sheer size of some hedge funds allows them space to manipulate the market and stock prices. They adjust their trading activity so they can push the direction of the stock in the way they deem fit
  • Through price manipulations, hedge funds can get abnormal returns from stocks that are often not so profitable to start with
  • Favorite hedge fund manipulation strategies include short selling, pump and dump schemes, and wash trading

Hedge Fund Operations

Hedge funds employ a wide variety of strategies that can focus on both long and short-term investment horizons. Also, their strong point is a diverse array of assets they can choose to invest in.

Potentially hedge fund investors can invest in a highly diversified portfolio, consisting of different assets located all around the world with different investment time horizons. This minimizes investment risk, which can be substantial depending on the strategy the fund uses, and how much they rely on leverage.

Some of the common strategies hedge funds use are:

  • Long/short equity: Hedge funds invest in both ends of the markets - the losing and the winning ones. In the same period, they are betting that the long-term investment will pay off, while short-term bets will lose value.
  • Global macro: Managers from these funds are experts in exploiting global macro events. Situations like elections, law changes, wars, and similar larger events can trigger a change in market direction which can be exploited by institutional investors.
  • Event-driven: This strategy emphasizes capitalizing on corporate events. Managers are looking for signs of potential bankruptcies, mergers, acquisitions, and restructurings since these events can offer the potential to invest in discounted assets.
  • Quantitative strategies: A strategy that relies on the use of advanced computer models, machine learning, and math algorithms to make trading decisions. With the help of these techs, managers analyze large data sets to find patterns or statistical arbitrage opportunities in the market.
  • Credit-oriented strategies: Investing into distressed debt, corporate debt, or fixed-income securities is a high-risk strategy that has the potential for high gains. Funds opt to buy corporate bonds while they are cheap and wait until the target company makes a comeback.
  • Activist investing: Making changes from within the company is an approach that hedge funds take when they want to have a direct say in the company's operations and strategy. The fund buys a bigger share that comes with one or more board member positions. Through them, funds can guide the company in the direction they believe is the best for the shareholders.

Potential For Manipulation

To start off it is important to point out that not only hedge funds but all large market participants have the ability to influence stock prices. Depending on the strategy that is used, in some cases, it can cross into borderline stock price manipulation.

Large financial markets like once in the United States and the United Kingdom prohibit stock price manipulation, and institutions like the SEC and FCA are closely monitoring potential harmful activities.

Short selling is one of the most accessible ways to manipulate stock prices. Shorting essentially betting that the stock is supposed to decrease in value. Managers can try to manipulate their prices by spreading false or misleading information about them.

Pump and dump schemes involve traders or managers artificially pumping up the price of the stock. First, they aggressively buy stock to attract other investors. This doesn't have anything to do with the performance of the stock, but only with the scheming. Once others pile on, funds sell at inflated prices, with the rest of the investors left dealing with imminent price drops.

While activist strategies are completely legal and often beneficial for the shareholders, they also provide enough room for manipulation. For instance, a fund after acquiring a large stake in the company can announce major changes that will result in positives in their operations. This can push the price up, while the fund earns from short-term price fluctuations.

Bear raids are straight-up illegal if they include sharing false information. In case a hedge fund wants to short a stock, it can resort to misrepresenting the company's overall state to drive its value down. This information can lead to investors panic selling, driving their stock down and providing ample ground for the fund to earn a hefty profit from short selling.

Wash trading is another scheme that includes raising attention to the stock by frequent buying and selling of the same security. Other companies that follow the herd can join in and trigger a change in the stock price due to the increase in trading volume.

Hedge funds, especially big players, can in some cases work together and target the same securities creating a different narrative about it. In their combined effort they can aim to lower or raise the share price.

Hedge Funds Regulations And Prevention Of Manipulation

When looking at the scrutiny levels of various investment vehicles, hedge funds are loosely watched. After the 2008 GFC regulatory bodies did put additional constraints on hedge fund operations, but they still have room to try to exploit the market.

All hedge funds that manage over $100 million are required to be registered by the SEC and to file regular reports. This way hedge funds provide an additional layer of transparency and are monitored by required regulators.

Among several reports that are required by hedge funds are ADV and PF forms. Through ADV form, hedge funds disclose information about the fund and its management, while PF collects data on private funds.

Also, there are laws in place forbidding making trading decisions based on nonpublic information including insider trading regulations. Besides that regulatory bodies are constantly monitoring the market searching for unusual trading patterns that can point to manipulation.

Regulations are also in place regarding manipulation through short selling, including the uptick rule which prevents short sales from pushing the share price further down.

After the GFC in 2008, the Dodd-Frank Act was introduced putting additional scrutiny on hedge funds and their operations. The goal of the act is to shed more light on their activities and prevent malfeasance.

How Investors Can Protect Themselves

The best thing that every investor can do is to educate themselves and do their research. Once they understand how to conduct due diligence and what to look for in particular assets, there will be less of a chance of becoming a victim of manipulated stock prices.

Financial fundamentals like financial health, management track record, and industry landscape are just a few to monitor before making a bet.

Investors should also keep an eye on the trading volume. In the case of a higher volume, the reason behind it could be market manipulation.

A crucial element of due diligence is following news updates about all important aspects of the relevant companies and their respective industries. As a final risk precaution, consulting an investment advisor can always shed light on a suspected manipulation and help in choosing the correct way to invest.

When a potential investor reviews all these factors and puts them into perspective, it should help them minimize the chances of stock market manipulation by retail investors. In any case, we recommend all novice investors to follow our website, because we share proven information that can provide an essential basis for the development of everybody's investment career.