Trading on Private Information: Evidence from Members of Congress

• DOI: http://doi.org/10.1111/fire.12180
• Author: Serkan Karadas
• Published date: 01 February 2019
• Date: 01 February 2019

The Financial Review 54 (2019) 85–131

Trading on Private Information: Evidence

from Members of Congress

Serkan Karadas

Sewanee: The University of the South

Abstract

I examine the stock trades of members of Congress and find that over2004–2010 the buy-

minus-sell portfolios of powerful Republicans have the highest abnormal returns, exceeding

35% on an annual basis under a one-week holding period. Among powerful Republicans, the

abnormal returns are mostly concentrated in the portfolios of those with less trading experience.

I also find that the positive abnormal returns disappear after the Stop Tradingon Congressional

Knowledge (STOCK) Act was passed in 2012. My results imply that the STOCK Act affected

politicians’ incentives to trade on privateinformation, which they acquired through their power

and party membership.

Keywords: private information, informed trading, congressional trading, STOCK Act,

Congress

JEL Classifications: G12, G14, G18

Corresponding author: Department of Economics, Sewanee: The Universityof the South, 735 University

Ave,Sewanee, TN 37383; Phone: (931) 598-1211; Fax: (931) 598-3229; E-mail: skaradas@sewanee.edu.

I am grateful for helpful comments and suggestions from Richard S. Warr(the Editor) and the anonymous

referees. I also thank Ron Balvers, Stratford Douglas, Alex Kurov, Harry Turtle, Josh Hall, Minh Tam

T. Schlosky,Jorida Papakroni, Chris Bollinger, the seminar participants at West Virginia University, and

the participants at the 2014 Southwestern Finance Association, 2014 Eastern Finance Association, 2013

Southern Economic Association, and 2013 Pennsylvania Economic Association meetings for their helpful

comments and suggestions. All remaining errors are mine. This paper was previously titled as “Informed

Trading at Capitol Hill: Evidence from Congressional Trading” and was presented under that title.

C2019 The Eastern Finance Association 85

86 S. Karadas/The Financial Review 54 (2019) 85–131

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.

Former President Barack Obama, April 4, 20121

Alleged insider trading by members of Congress caused mounting public pres-

sure, which served as a catalyst for the passage of the Stop Trading on Congressional

Knowledge (STOCK) Act of 2012.2The STOCK Act was enacted “to prohibit Mem-

bers 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,

e.g., Ziobrowski, Cheng, Boyd and Ziobrowski, 2004; Ziobrowski, Boyd, Cheng and

Ziobrowski, 2011). Also, there are still unanswered questions such as Do politicians

actually trade on private information, or do they possess superior skills?;What deter-

mines access to private information?; and so forth. Furthermore, there is an ongoing

debate on whether the STOCK Act was really necessary and whether it had any

purpose beyond improving Congress’s image.

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, I ask whether politicians trade on private information. If they do, I

strive to understand the nature of their privateinformation and to find out what factors

contribute to their access to private information. The possibility existsthat politicians

1http://www.whitehouse.gov/blog/2012/04/04/president-obama-signs-stock-act

2For example, see Economist (2011) and Kroft (2011) for the public’s viewof congressional trading.

3http://www.gpo.gov/fdsys/pkg/PLAW-112publ105/pdf/PLAW-112publ105.pdf

4See ElBoghdady and Hamburger (2013a,b) and Yang,Hamburger and ElBoghdady (2013) for some of

the press coverage by the Washington Post on this incidence of alleged insider trading. The Wall Street

Journal also covered this story (see Mullins and McGinty,2013a,b,c,d; Mullins, Strasburg and McGinty,

2013).

S. Karadas/The Financial Review 54 (2019) 85–131 87

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

toward pursuing their self-interests. For example, Buchanan (1989, p. 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.”

I build my empirical framework on transactions-based calendar time portfolios

using 61,998 stock trades that politicians made over the 2004–2010 period. I first

separately calculate the returns on a portfolio that contains the stocks bought by

politicians and the returns on a portfolio that contains the stocks sold by politicians

(i.e., previously long positions). I refer to these portfolios as the buy portfolio and the

sell portfolio, respectively. I assume five holding periods, ranging from one week to

one year, in my return calculations. For example, under a one-week holding period,

a buy transaction stays in the buy portfolio for one week and then it gets discarded.

Likewise, a sell transaction stays in the sell portfolio for one week and then it gets

discarded. My empirical analysis focuses on the return differences between the buy

portfolio and the sell portfolio (i.e., the returns on the buy-minus-sell portfolio).5

I document that the portfolios of powerful politicians (those with powerful com-

mittee assignments) outperform the market by more than 20% on an annual basis

under a one-week holding period. However, therei svery weak evidence of informed

trading for nonpowerful members of Congress. Among powerful politicians, the port-

folios of Republicans outperform the market by more than 35% on an annual basis

under a one-week holding period. This superior performance persists even after Re-

publicans lost majority control of Congress in the 2006 elections. On the other hand,

the portfolios of Democrats mostly earn average returns, even when they controlled

Congress. My further analysis of powerful Republicans’ transactions reveals that the

portfolios of inexperienced (i.e., unsophisticated) investors earn abnormal returns

under a one-week, one-month, two-month, and three-month holding period, whereas

the abnormal returns on the portfolios of experienced (i.e., sophisticated) investors do

not extend beyond a one-week holding period. This result implies that the abnormal

returns are driven mostly by private information, not by trading experience or skill.

I present evidence that both the advisor-assisted and the self-managed port-

folios of unsophisticated powerful Republicans earn abnormal returns, suggesting

that politicians obtain some of their private information from their financial ad-

visors. I explore whether powerful Republicans also acquire private information

through their interactions with firms that provide them with campaign contribu-

tions and through their involvement in the purchasing decisions of the federal gov-

ernment. I find evidence that these channels produce economically significant, but

5It is important to note that the sell side of the buy-minus-sell portfolio contains the stocks that politicians

sold, not those that politicians shorted. For example, let us suppose that politician A owns shares of ABC

Inc. in her portfolio. When she sells shares of ABC Inc., this transaction becomes part of the sell portfolio.