Trading by politicians is increasingly scrutinized, with recent legislation prohibiting trading by politicians being introduced in Congress. There have been numerous scandals involving insider trading, such as trading prior to COVID lockdowns or trading ahead of government contract awards or FDA reports. Some politicians, however, claim that restrictions on their trading violates their economic freedom and adversely impacts their ability to save for retirement.
The existing academic research on trading by politicians is focused primarily on ethical issues and the profitability of their trading strategies. But in our recent study, we analyze the information conveyed in trading by U. S. senators and find that their trading under the Stop Trading on Congressional Knowledge Act of 2012 (STOCK) is largely misunderstood and misinterpreted.
First, the STOCK Act is only binding on congressmen and senators and their immediate family members. It does not cover staffers, aids, or even state-level legislators. This exclusion applies even though these individuals have access to the same level of information as the legislators they support. Consequently, thousands of individuals have access to the same information as congressional members but are not restrained in their trading. Second, per the STOCK Act, politicians do not need to report transactions of stock indexes and ETFs. While it can be argued that these securities are well diversified, politicians can still time their trade and earn substantial returns and trade portfolios of various market sectors without scrutiny. Finally, and most significantly, the STOCK Act does not address the information that politicians share with investment funds or other financial institutions.
This last point is most crucial. Politicians can selectively share information about upcoming legislation or other private information with any corporation or financial institution. This sharing can produce a significant market impact. This possibility was recognized when the STOCK Act was introduced, and there was a call to study the effect of this information sharing on the equity markets. This study, however, was never undertaken. It is currently assumed by the public that only politicians trade on their inside information, which should not significantly impact the market. But if politicians can selectively share their private and economically relevant information with institutional market participants, then market integrity and efficiency might be compromised.
Our study tests the information content of senatorial transactions by aggregating their monthly industry trades. We contend that politicians are most likely informed at the industry rather than firm level. We justify this assumption on the broad charge given to senatorial committees, the comprehensive scope of federal legislation, and the industry focus of most lobbyists who meet with politicians.
We find that the information contained in this trading significantly affects an industry’s risk and return. Both senatorial buys and sales predict various measures of risk for firms within an industry: volatility, bid-ask spread, and idiosyncratic volatility.
While several measures of political risk are explored in the literature, they cannot capture its more immediate effects. Most measures are constructed using donation or lobbying data and thus change only annually or less frequently. Our measure of political risk, senatorial equity trading, changes monthly and thus allows us to capture the most dynamic aspects of political risk.
Our new measure of political risk allows us to study the impact of this information asymmetry across industries. We can also study how this information advantage affects individual firms within an industry. We speculate that size will be a major factor in how a firm is affected by the informed trading of senators. We find that large firms are primarily unaffected in terms of risk and can earn abnormal market returns. Small firms, however, are adversely impacted in terms of risk and suffer negative market-adjusted returns. Institutions primarily invest in large firms and rarely invest in smaller companies. Due to their political connections, these institutional traders are less affected by uncertainty and are generally informed before the information becomes public. Similarly, large corporations make significant political contributions and fund lobbyists. They are likely to be well-informed about pending legislation. As such, they can better prepare for regulatory, policy, or tax changes and be relatively unaffected in the long term.
Finally, a question remains regarding what factors/information drives political trading. While senators are privy to multiple sources of information, we observe that trading activity is significantly associated with future legislative actions. We find that trading activity in specific industries predicts the number of bills introduced to affect a given industry.
Overall, our study provides insight into a new aspect of political trading beyond its ethics and profitability. We examine whether politicians might be selectively informing investment funds and financial institutions with private and economically relevant information. One of the critical assumptions for market efficiency is that information is costless and simultaneously available to everyone. This assumption is not satisfied if institutions receive information from politicians before public announcements. While the ethics of trading by politicians can be questioned, it is unlikely to impact the market significantly. If large financial institutions can trade ahead of such information, then the impact can be severe, and investors without political access will suffer.
This exclusion in the current STOCK Act has been ignored, and efforts to curb insider trading by politicians do not address this loophole. The most likely result of any proposed legislation is that politicians will be compensated for the information differently, political information gathering will persist, and we will lose the ability to analyze it. Only legislation that seeks to stop selective information sharing with prominent institutional market players and their related associates can mitigate the problem.
Jan Hanousek Jr. is an Assistant Professor at Fogelman College, Department of Finance, Insurance, and Real Estate of the University of Memphis.
Jan Hanousek is a Full Professor at Mendel University in Brno.
Stephen Ferris is a Dean at Eberly College of Business at Indiana University of Pennsylvania.
This post was adapted from their paper, “Peering into the Crystal Ball: The Information Content of Legislative Trading,” available on SSRN.
