Insider trading – all the cool kids are doing it

April 11, 2013

By James Saft

(Reuters) – There are a bunch of kids out there trading on inside information, and you, me and the rest of the economy are paying the price.

A study of trading patterns in Finland shows a highly suspicious pattern of activity in accounts held on behalf of juveniles.

In reality, it is probably not the kids themselves who are playing at being junior insider traders, but instead it is their guardians who are likely using juvenile accounts as a safer way to profit from non-public knowledge.

What’s worse, the data also demonstrates how the market detects which companies’ stocks are most plagued by “informed investing” and then imposes a penalty which effectively reduces both investor returns and overall economic growth.

KID TRADERS

Using data on a half a million accounts from Finland from 1995 to 2010, the study came to a surprising conclusion: accounts set up to benefit kids 10 years and under did really well at stock picking, and did especially well just before mergers, earnings releases and events that generate big stock moves.

The analysis was possible since Finland makes available unusually detailed information about the identities of investors.

“When guardians trade through under-aged accounts, there is a relatively high probability that they are trading on private information,” the authors, Henk Berkman, at University of Auckland, Paul Koch at the University of Kansas and Joakim Westerholm at the University of Sydney, conclude in a paper slated to be published in the Journal of Finance.

The gap between the junior set and typical accounts held by adults was striking: in the day following trades made by kids, their accounts outperformed the adult accounts by 9 basis points.

Ahead of major earnings announcements, the kids chose correctly whether to buy or sell 57 percent of the time and beat their elders by 1.1 percent in the following day.

It gets even better – at least for junior. On trades made the day ahead of a merger announcement, juvenile portfolios outperformed by 12 percent the following day, and made the right decision to buy or sell an uncanny 72 percent of the time.

The rest of the market, by the way, chose correctly whether to buy or sell only 50 percent of the time.

This is probably not all due to inside knowledge, according to the study. The guardians tended to be richer and may simply have been more successful at investing, the authors argue, due perhaps to higher intelligence or an advantage in obtaining legal, but valuable information.

Even so, the fact that the juvenile accounts outperformed ahead of mergers while the guardians’ accounts did not implies that the adults were smart enough to know better than to trade on inside knowledge in an easily traceable way.

HIGH COST OF CHEATING

When the authors looked at the stocks with the highest proportion of trades by juvenile accounts, they found something else to ponder: the Finnish stock market as a whole liked them less than the rest of the market.

In other words, those stocks were punished by investors, who demanded a higher return to compensate for their risks.

“If an uninformed investor perceives a greater likelihood of trading against informed investors, that uninformed investor is likely to demand a higher required return to buy such a stock,” Paul Koch said in an email.

“Put another way, the uninformed investor is likely to be willing to only buy this stock if the price is lower (and thus the expected return required to invest in this stock is higher).”

What this all boils down to is that anyone who owns a stock thought likely to be subject to insider trading is hurt. So is the company, whose cost of capital rises the lower the value the market places on its shares.

While some argue that controls on insider trading are wrong-headed, in that they tend to slow down the spread of information, I’d counter that this study points to the real and important costs.

People don’t like being cheated and they don’t like doing business with cheats. To protect themselves, investors will often impose penalties with very high costs all round. Funding the Securities and Exchange Commission is one such cost, as was Martha Stewart’s room and board while she was in prison.

To give a broad example, if Alexander Graham Bell had been a known scoundrel, liable to cheat all his business partners, he would have found it harder to raise money to develop the telephone, thus slowing the adaption of an otherwise useful technology.

A society with more insider trading will, all else being equal, allocate capital less well, and grow more slowly.

If this is happening in Finland, which is ranked as being the least corrupt nation on earth, it is definitely happening elsewhere.

Time for the SEC to get cracking.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(Editing by Chelsea Emery)

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If there is a way to cheat, some people will figure it out.

Is it any wonder that the financial services industry wages a continuous lobbying war against any regulation that would encumber “free markets”?

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