Wednesday, January 05, 2005

It is not a level field---Tipping by Irvine, Lipson, & Puckett

SSRN-Tipping by Paul Irvine, Marc Lipson, Andy Puckett

No we are not talking what you leave at restaurants. Tipping here is the idea of giving stock tips to select customers prior releasing the recommendation to all of their clients. It is important to realize that tipping is not illegal. While some brokerage firms have rules against it, tipping in and of itself is not illegal.

Irvine, Lipson, and Puckett use a "proprietary database" to examine unusual trading activity around initial recommendations. The authors find:

a significant increase in institutional trading and abnormal buying beginning about five days prior to the public release of analysts' initial reports(initiations). We confirm that institutions buying in advance of the initiation earn abnormal profits."

Importantly, this trading leads to positive returns:

"institutions buying prior to the recommendation release earn positive abnormal trading profits".
It is possible that this unusual activity is caused by the institutions forecasting when the analysts would issue recommendations. The authors attempt to address this and give fairly convincing proof that it is not the case. Their most convincing evidence is that this unusual trading activity begins at the same time the analysts would have finished the report and passed it on for internal review prior to public disclosure.

While not totally unexpected, the finding that certain institutional investors trade PRIOR to initial buy or strong recommendations is not good from a "level playing field" perspective. But it does lead to the important question:

Is tipping good or bad?

It is not as easy of question as one might originally suppose. For instance, the authors make an excellent point in their discussion:

"...The trading profits that tipping provides to large institutions are likely to be one of the services large institutions expect from analysts' firms. If tipping were precluded, institutions would be less willing to pay for sell-side research and, consequently, the amount of price relevant sell-side research would be reduced. For this reason, the social welfare implications of tipping are unclear...."

That said, I would still like to see a more level field and more transparency.

Definitely interesting and well worth a read! I still have some reservations about whether this is actual total proof of tipping. It could still be that the institutions are not just seeing the same things that lead the brokerage to initiate coverage, but am almost convinced. ;)

Cite: Irvine, Paul J., Lipson, Marc Lars and Puckett, Andy, "Tipping" (December 2004). AFA 2005 Philadelphia Meetings.

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