Trading on Private Information: Evidence from Members of Congress Date posted: January 9, 2016
This paper investigates whether members of Congress use private information in their stock transactions. We analyze 61,998 congressional common stock transactions over the 2004-2010 period, and find that the buy-minus-sell portfolios of powerful Republicans outperform the market with abnormal returns exceeding 32% under a one-week holding period. These abnormal returns persist under both Democratic- and Republican-controlled Congresses. Furthermore, the portfolios of powerful Republicans with less trading experience (i.e., unsophisticated) outperform those of sophisticated powerful Republicans. Also, the advisor-assisted and self-managed portfolios of unsophisticated powerful Republicans both earn abnormal returns. Our results imply that the performance of congressional portfolios is mostly driven by private information that politicians acquire from sources inside and outside of Congress, based on their power and party membership.
Trading on Private Information
1. Introduction The STOCK Act makes it clear that if members of Congress use nonpublic information to gain an unfair advantage in the market, then they are breaking the law. It creates new disclosure requirements and new measures of accountability and transparency for thousands of federal employees. That is a good and necessary thing. We were sent here to serve the American people and look out for their interests – not to look out for our own interests. President Barack Obama, April 4, 2012. 1 Alleged insider trading by members of Congress caused mounting public pressure, which was a catalyst for a change in the passage of the Stop Trading On Congressional Knowledge (STOCK) Act of 2012.2 The STOCK Act was enacted “to prohibit Members of Congress and employees of Congress from using nonpublic information derived from their official positions for personal benefit, and for other purposes.”3 Legislating the way that members of Congress trade stocks has received a great deal of media attention, but there are very few academic studies on this issue (see Ziobrowski et al., 2004; 2011 for examples). Also, there are still unanswered questions such as Do politicians actually trade on private information or do they possess superior skills?, What determines access to private information?, etc. Furthermore, there is a debate on whether the STOCK Act was really necessary and whether it had any purpose beyond improving Congress’ image (Eggers and Hainmueller, 2013).
Trading on Private Information
Members of Congress (politicians) differ from ordinary traders in that they generate or have access to private information that has the potential to move stock prices substantially. For example, the Washington Post reports that there was an unusual trading activity in the options of Humana, a health insurer, after a staffer on the Senate Finance Committee, talked about the prospects of a critical Medicare bill in a conference call organized by Capitol Street, a consulting firm, on March 18, 2013. On April 2, 2013, the government officially announced a rate increase for Medicare-participating insurers, which generated 500% or more returns on the options bought right after the conference call.4 In this paper we ask whether politicians trade on private information. If they do, we strive to understand the nature of their private information and to find out what factors contribute to the access to private information. There is a possibility that politicians may choose not to trade on private information even if they possess it. However, public choice theory suggests that politicians, like any other individual, also work towards pursuing their self-interests. For example, Buchanan (1989, pg.20) states that “individuals must be modeled as seeking to further their own self-interest, narrowly defined in terms of their measured net wealth positions, as predicted or expected.” We build our empirical framework on calendar-time transaction-based portfolios. We construct these portfolios using 61,998 stock trades that politicians made over the 2004- 2010 period. We document that the portfolios of powerful politicians (ones with powerful committee assignments) outperform the market by 22.13% to 24.16% under a one-week holding period on an annual basis. However, there is very weak evidence of informed trading for non-powerful members of Congress. Among the powerful politicians, the portfolios of Republicans outperform the market by 32.05% to 36.19% under a one-week holding period. This superior performance persists even after Republicans lost the control of Congress in the 2006 elections. On the other hand, the portfolios of Democrats mostly earn average returns. This mediocre performance persists even in the periods that Democrats controlled Congress.