Is the Securities and Exchange Commission a warren for insider trading? If you’ve read recent headlines like “The Incredible Stock-Picking Ability of SEC Employees,” you’d think so.
The likely truth, however, is that not only is no insider trading going on, but that the S.E.C. staff members are just as bad as the rest of us at picking stocks.
The suggestion that the staff committed insider trading stems from a draft paper by Professor Shivaram Rajgopal of Emory University and a doctoral student at Georgia State, Roger M. White, banally titled “Stock Picking Skills of SEC Employees.” The paper is an early draft, and according to Professor Rajgopal, it was not meant to be publicly circulated. It was posted internally at the University of Virginia for a talk and was picked up by the news media, unintentionally as far as the authors were concerned.
It’s a really clever paper, though, even in its early form. The authors made a Freedom of Information Act request to the S.E.C. for all trading data by the agency’s employees from late 2009 through 2011. The authors then analyzed the data for abnormal trading by S.E.C. staff.
The authors conclude that “S.E.C. employees continue to take advantage of nonpublic information to trade profitably in stocks under their regulatory purview.” And from that line came the suggestions that S.E.C. staff members may have been committing insider trading.
When you read the paper, you find that the authors’ conclusions are much more limited. In response, the S.E.C. explained that any abnormal trading was because employees were forced to sell certain stocks if they were about to begin an investigation related to those companies. So the title of the paper could have perhaps been “S.E.C. Staff Profits Handsomely Through Dumb Luck.”
In reality, the paper found that the S.E.C. employees did not earn any abnormal return when purchasing stocks (abnormal returns here is a term of art and simply means that the S.E.C. staff made more than what would be expected for an investor without inside information or stock-picking skill – a so-called “uninformed investor”). It found that the S.E.C. staff members buy stocks just like any “uninformed investor,” meaning they earn what anyone else would – the market return. So far, so good.
However, the authors also found that the S.E.C. staff is abnormally good at selling stocks at the right time. When the agency staff members sold during the period analyzed, the authors found, they made gains of approximately 8 percent above the “uninformed investor.” In other words, the agency’s staff members were dumping their shares before bad news, such as – not coincidentally — an S.E.C. investigation.
This finding of the gains is based on analyzing what an uninformed stock portfolio would make over a 12-month period and comparing it to what the S.E.C. staff members actually made. Yet, time horizons this long are likely to be affected by other events. The authors didn’t use shorter time frames, which might have helped make their case stronger.
The second finding of the authors is that of 56 S.E.C. investigations examined, it appears there was trading by agency employees in six cases in advance of the public announcement of the investigation.
The authors’ third finding concerns the sale of stocks around the filing of 144 notices, which are mostly paper filings by insiders recording a sale of stock. Because they are filed via paper rather than electronically, they have a longer period before the made widely available to the public. The authors find that in this period, the S.E.C. staff members sold stocks with 144 notices at a greater level than buying such stocks.
The first finding – that S.E.C. staff members appear to sell shares with abnormally good timing – is an important one, even though it may be just a function of their job requirements.
The other two findings are interesting, but hard to draw conclusions from other than they provide some support for the main finding. The authors’ discovery that there was trading around six investigations is simply not a sample meaningful enough to make any conclusions. As for the larger number of sales around the filing of 144 notices, the authors do not look at the returns around these sales. Finding more selling than buying, but without knowing the returns, may be simply be a timing issue.
Once the paper was publicized, the S.E.C. responded with its own explanation. John Nester, an S.E.C. spokesman, said that “each of the transactions was individually reviewed and approved in advance by the ethics office.” He continued that “most of the sales were required by S.E.C. policy. Staff had no choice. They were required to sell.”
The explanation appears to jibe with the fact that the authors found abnormal returns for sales and not purchases. Assuming that it is indeed correct, this is not insider trading. There is no intent here to give ill-gotten gains to S.E.C. staff, and indeed none has been alleged.
The gains, if they are there, are simply because of a staff rule, and likely gains that no one was aware of before. This is probably why there is more S.E.C. staff selling rather than buying, based on the 144 notices that were analyzed. The S.E.C. staff must also sell when they take employment with the agency to come into compliance with the ethics requirements, and so this likely also creates more biases toward sales.
Given the agency’s response, I suspect that the authors will tone down the parts about insider trading and add some more analysis that affirms the S.E.C.’s story. If nothing else, the authors now have another explanation for their findings.
In the meantime, the kerfuffle about the “insider trading” has also obscured another finding in the paper. The authors found only 7,200 trades amounting to about $66 million worth of stock over a three-year period. That is two trades per employee over that time. That is hardly the stuff of market-timers and day traders.
The paper also found that the S.E.C. staff is composed of bad stock pickers. Staff members earned abnormal returns when investing in common stocks (because of the selling), but they lose money buying and selling foreign stocks and exchange-traded funds, and appear to be following the pattern of other investors when trading everything but common stock.
Like everyone else, S.E.C. staff members rode the technology wave heavily (making 1,181 trades in these stocks). Pharmaceutical stocks were the second-favorite choice with 390 trades. Here’s a shocker: During the period, Apple (a stock with one of the highest market values) was the most popular stock for S.E.C. employees. Does this sound like a sophisticated bunch of traders trying to gain an edge that no one else has?
If the S.E.C.’s sale rule had not existed, the paper would almost have certainly been about how bad even the agency’s own employees are at buying and selling stocks. But the rule exists, as do the paper’s findings on sales.
If the paper’s empirical findings hold up, this will be its value and it will be quite a good paper. It will show that the S.E.C. might want to rethink its sale rules for when investigations are initiated. The agency may also want to revisit its stock holding rules generally. But under no circumstance is there any evidence in this paper that the policy is promoting insider trading. Dumb luck maybe, but not insider trading.