A recently released working paper by Meng Gao and Jiekun Huang of University of Illinois at Urbana-Champaign has examined how hedge funds have historically benefitted from political information they gain from their connections to lobbyists and politicians. In addition to demonstrating the significant financial returns to being a Washington insider – a topic we spend a lot of time on here at Sunlight – Gao and Huang seem to have found that the STOCK Act is making a difference.
The paper grouped hedge funds into two types for each quarter they were actively trading: connected funds (those who had hired lobbyists that quarter), and non-connected funds (those who had not hired lobbyists that quarter).
Gao and Huang proposed that if being politically connected actually provided financially beneficial information, connected funds’ portfolios should outperform non-connected funds, particularly with respect to their holdings of politically sensitive stocks (stocks of companies more likely to be impacted government activity). To examine this, they looked at how each funds’ portfolio of politically sensitive stocks performed compared to their portfolio of non-politically sensitive stocks, and compared these differences between connected and non-connected funds.
Here is where it starts to get interesting. Gao and Huang found that connected funds are measurably more active when it comes to politically sensitive stocks. They found that politically connected funds trade in politically sensitive stocks 1.6 percentage points (or 22 percent) more than non connected funds (by volume), and allocate 1.2 percentage points (or 16.8 percent) more of their portfolios to politically sensitive stocks. (pp. 14-15)
These connected funds overweight their politically sensitive holdings because those holdings are really successful. Hedge funds that have hired lobbyists, according to Gao and Huang have politically sensitive holdings of that tend to over-perform by 63 to 87 basis points per month (a basis point is 1/100th of 1%). The best explanation for this over-performance, given everything the authors have controlled for, is the information advantage these funds have because of their access to those in the know in Washington.
Gao and Huang conducted their study looking at hedge fund data from 1998 – 2013. As you may remember from our extensive writing on the STOCK Act, something interesting and relevant to this research happened during that period in 2012: The STOCK Act passed.
The STOCK Act extended insider trading laws to cover trading on the type of political information these hedge funds had been benefiting from for most of the time period that Gao and Huang studied.
The passage of the STOCK act presented an exogenous shock to the system and an exciting opportunity for a quasi natural experiment. This allowed Gao and Huang to test whether the performance of the same funds under essentially the same conditions (except for new STOCK Act rules) were notably different. And when they focused in on the year immediately before and the year immediately after the passage of the STOCK Act, they found a significant difference.
After the STOCK Act, the significant over-performance of portfolios of politically sensitive stocks held by connected funds they had seen previously disappeared. They subjected this finding to a bunch of robustness checks. I recommend checking out the paper, if you are interested in the details.
As the authors note, this finding is compelling evidence that the threat of insider trading liability has, in fact, decreased the flow of political information to connected funds.
In short, the law might be working.