There has been a lot of talk over the last few years about money in politics and just what kind of influence money buys in Washington. This is a serious issue for America, deserving of all the time and effort so many people are putting into addressing this problem. Interestingly, however, not so much attention has been focused on the other side of the money-influence question: what do politicians actually get from access to lobbyists and control over the legislation lobbyists help to create or destroy? This question came suddenly to my mind in the course of reading Nate Silver’s excellent book, The Signal and the Noise. In it, Silver makes an interesting comment in the chapter where he addresses the issues of market efficiency and insider trading:
There is fairly unambiguous evidence that insiders make above average returns. One disturbing example is that members of Congress, who often gain access to inside information about a company while they are lobbied and who also have some ability to influence the fate of companies through legislation, return a profit on their investments that beats market averages by 5 to 10 percent per year, a remarkable rate that would make even Bernie Madoff blush.
As basis for his claim, Silver footnotes a paper by Alan J. Ziobrowski, Ping Cheng, James W. Boyd, and Brigitte J. Ziobrowski entitled, “Abnormal Returns from the Common Stock Investments of the U.S. Senate,” which they published in the Journal of Financial and Quantitative Analysis (Vol.39, No.4, 2004). I decided to track it down and read it for myself, and it makes for fascinating reading.
In their research, the authors decided to test an assumption that many people may have held but none had tested. As they note:
Our goal in this research is to determine if the Senators’ investments tend to outperform the overall market, which would support the notion that Senators use their informational advantage for personal gain as suggested by public choice theory. We test whether common stocks purchased and sold by U.S. Senators exhibit abnormal returns.
As the basis for their research, the authors collected every stock transaction reported by members of the U.S. Senate from 1993-1998 (which they must report by law). Initially, they began with 6,052 transactions, screened as follows:
Only U.S. common stocks are included in the study. These screens eliminate, among other things, all preferred stock, ADRs, REITs, foreign stocks, and mutual funds. We also eliminate all initial public offerings (IPOs) from the sample. In total, 360 observations are eliminated for the reasons given above. Among the surviving transactions, approximately 59% of the stocks are listed on the NYSE, 40% are traded on the NASDAQ, and about 1% are listed on the ASE.
The authors note that Senators’ transactions are typically reported long after they occur (as much as 17 months later), so the results of their analysis would not be based on instantaneous market reactions but on longer-term stock performance.
You will probably not be shocked to learn that U.S. Senators turn out to be some of the best stock-pickers in America:
Using the calendar-time portfolio approach with the Fama-French three-factor model and the Capital Asset Pricing Model (CAPM), a portfolio that mimics the purchases uf U.S. Senators on a trade-weighted basis outperforms the market by 85 basis points per month, while a portfolio that mimics the sales of Senators underperforms the market by 12 basis points per month.
For Senate stock purchase transactions, the abnormal returns are both economically large and statistically significant. When measuring cumulative daily abnormal returns we find that the cumulative daily abnormal return from common stocks purchased by Senators is more than 25% during the 12 calendar months immediately following acquisition. Common stocks sold by Senators exhibit slightly positive cumulative abnormal returns throughout the year following the sale. But during the 12 months prior to sale, the cumulative daily abnormal return is also over 25%, peaking close to the time of sale.
In other words, Senators are extremely good at knowing when to buy a stock that is about to go on an upward run and very good at knowing when to sell a stock about to take a dive.
The authors were also curious about whether such amazing returns had anything to do with party affiliation, given that many people believe that Republicans are “the party of business.” What they found during this subsequent analysis is also telling: “When transactions made by the Senators are separated by political party, we find no statistically significant differences between the abnormal returns of Democrats and Republicans.” So party affiliation did not make much of a difference; however, Senate seniority certainly did, although not as one might expect. As the authors further note: “The common stock investments of Senators with the least seniority (serving less than seven years) outperform the investments of the most senior Senators (serving more than 16 years) by a statistically significant margin.”
So what do the authors conclude after looking at thousands of Senate stock transactions? The answer will hardly surprise you:
Taken collectively, the results of these analyses are economically very significant. Barber and Odean (2000) measured common stock returns for 66,465 randomly selected households in the U.S. from 1991 to 1996 and found that the average household underperformed the market by approximately 12 basis points per month. Jeng, Metrick, and Zeckhauser (2001) examined the returns to corporate insiders when they traded shares of their respective company’s common stock during the period 1975 to 1996 and found that insiders earned an economically significant positive abnormal return of 50 basis points per month. In comparison, we find that members of the U.S. Senate outperformed the market by almost 100 basis points per month.
In other words, stocks transactions made by this sample of U.S. Senators generated returns twice as high as those made by corporate insiders. As the authors note with some understatement, “the economic returns earned by the Senators are extraordinarily large.” Furthermore, since the results were consistent across the board and not skewed by a few extraordinarily lucky traders, the authors conclude that “the persistence of positive statistically significant abnormal returns would suggest that trading with an informational advantage is reasonably widespread among Senators who trade.”
Now, at this point, you may be thinking that this ultimate form of insider trading, which is explicitly forbidden for many government employees, would be illegal, but, as the authors note, it’s not:
It should be noted that these results should not be used to infer illegal activity. Current law does not prohibit Senators from trading stock on the basis of information acquired in the course of performing their normal Senatorial functions.
Moreover, the authors note that their analysis is just the tip of the iceberg:
The results of this study warrant further investigation. Senate committees can be studied for abnormal returns and examined to determine if Senators serving on committees disproportionately invest in companies under their committee’s Jurisdiction. Membership on certain key committees may provide Senators with better investment opportunities than other committees. Connections between campaign contributions and common stock transactions also seem like fertile ground for further study. We recommend that the financial transactions of members of the U.S. House of Representatives, high-ranking officials of the Federal executive branch, and Federal judges should all be examined and tested in future research.
In fact, the same authors published a follow up paper in 2011 that focused on House members, and the results of that analysis were, not surprisingly, similar:
Consistent with the study of Senatorial trading activity, we find stocks purchased by Representatives also earn significant positive abnormal returns (albeit considerably smaller returns). A portfolio that mimics the purchases of House Members beats the market by 55 basis points per month (approximately 6% annually).
I have written more than one piece arguing that insider trading should be legal, not because it is a good thing but because it would force investors to acknowledge the fact that it is widespread, systemic and persistent. These studies are yet more evidence that insiders, corporate and governmental, routinely use nonpublic information for personal gain in ways that individual small investors cannot. Instead of pretending that regulators such as the S.E.C. have a handle on this problem, we should admit that traders, executives and even members of our government routinely exploit informational asymmetries for unfair personal gain. It is ridiculous to claim otherwise, given that study after study, and court case after court case, shows that the war on insider trading, like the one on drug use, cannot be won by any government, much less one where those doing the best trading with insider information as the lawmakers themselves.
In the meantime, you may not be able to replicate Lyndon Johnson’s famous performance of turning an initial $17,000 investment into a multi-million dollar media company, but perhaps you can get your Senator and Representative to start sharing stock tips next time they’re in town.