Capitalizing on Capitol Hill: Informed Trading by Hedge Fund Managers

Jiekun Huang is an Assistant Professor of Finance at the College of Business at the University of Illinois Urbana-Champaign. This post is based on a forthcoming article by Professor Huang and Meng Gao, doctoral candidate in finance at the College of Business at the University of Illinois Urbana-Champaign.

Governments play an increasingly prominent role in influencing firms and stock prices. According to a Duke University/CFO Magazine Business Outlook Survey in 2013, federal government policies rank second only to consumer demand among the top three external concerns corporations face. The profound effects of political decisions on corporate performance and stock prices are evidenced by recent government policies and actions such as the bailouts of AIG and Bear Stearns, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the Affordable Care Act. As a result, information regarding political decisions is of considerable interest to financial market participants. Yet, little is known about the dissemination and incorporation of political information or its value to financial market participants. In our paper, Capitalizing on Capitol Hill: Informed Trading by Hedge Fund Managers, we test the hypothesis that hedge fund managers obtain and trade on political information through their connections with lobbyists.

Lobbyists have access to political information because they routinely exchange information with legislators and many are themselves former legislators. A Wall Street Journal (2006) article reports that hedge funds find Washington to be a “gold mine of market-moving information.” [1] By hiring lobbyists, hedge fund managers can gain access to information about ongoing or impending government actions. As an example, consider the case of USG Corp., a building-material company facing an estimated $5.5 billion in asbestos-related lawsuits. On November 15, 2005, the company’s stock was traded at 200% of its normal trading volume and delivered an abnormal return of almost 5%, yet no company-specific news was released on that day. On the following day, the Senate Majority Leader announced a plan to create a $140 billion bailout fund to relieve companies such as USG Corp. of their asbestos liabilities. It appears that the market reacted before the public announcement, which led the financial press to speculate that some investors traded ahead of the news, guided by consultants on “political intelligence” (Business Week, 2005). [2]

The practice of lobbyists passing on material nonpublic political information obtained from within Congress to hedge funds has raised concerns among regulators, because it can compromise the integrity of the political process. The fact that members and employees of Congress were able to use confidential information acquired as a result of holding public office for personal gain could undermine the public trust placed in them; more disturbing is the possibility that it may lead to legislative decisions that would maximize private gain to lawmakers rather than serve the public interest. Before 2012, trading by hedge funds on private political information obtained from within Congress did not violate insider trading laws because, first, neither the tippers (members of Congress and their staffers) nor the tippees (hedge funds) owed fiduciary duties to the issuers of the securities in which the hedge funds trade, and second, it was commonly believed that the tippers did not owe a duty of trust and confidence to the source of information. The Stop Trading on Congressional Knowledge (STOCK) Act, signed into law in April 2012, imposes a duty of trust and confidence on government officials, thus exposing hedge funds that trade on private political information to potential insider trading liability. Nevertheless, the opaque nature of the political intelligence industry and enforcement challenges associated with the law have sparked an ongoing debate about whether it is necessary to institute a new law to specifically govern the transfer of political information in financial markets.

Our research provides evidence on how hedge funds benefit from access to political information. We make use of a large data set on long-equity holdings of hedge funds from 1999 through 2012 as well as a database of federal lobbying expenditures in the U.S. to identify potential information transfers from lobbyists to hedge funds. If hedge funds gain an informational advantage through their connections with lobbyists, connected hedge funds should trade more actively in stocks that are sensitive to political decisions than non-connected funds. Connected hedge funds should also outperform non-connected hedge funds on their politically sensitive holdings. We refer to this as the information transfer hypothesis.

We find evidence that connected funds trade more actively in politically sensitive stocks. On average, connected funds’ trading volume (inferred from quarterly holdings) in political stocks accounts for 24.44% of their total trading volume, compared with 18.67% for non-connected funds; the difference remains after controlling for various fund characteristics. Moreover, connected funds tilt their portfolio holdings more heavily towards political stocks than non-connected funds. These findings are consistent with our information transfer hypothesis.

We then examine whether the political holdings of connected funds outperform passive benchmarks. We construct calendar-time portfolios that mimic the aggregated portfolio allocations of connected and non-connected hedge funds by assigning stocks in each hedge fund portfolio to one of the two-by-two matrix of portfolios based on whether the hedge fund is connected and whether the stock is politically sensitive. We find that connected hedge funds earn higher returns on their political holdings. A strategy of buying a mimicking portfolio of political holdings by connected funds delivers an abnormal return of 56 to 93 basis points per month, suggesting that connected funds possess an informational advantage in trading politically sensitive stocks. Furthermore, we construct a spread portfolio in the spirit of a difference-in-differences analysis. The tests show that connected funds, compared with non-connected ones, yield a monthly abnormal return of 69 to 89 basis points higher on their political positions than on non-political ones. This evidence suggests that the outperformance of connected funds on political holdings is not driven by the generally superior stock-picking abilities of connected fund managers or by political stocks in general delivering superior returns.

Understanding the flow of political information and the extent to which political information has value to certain financial market participants like hedge funds carries important implications. From a policy perspective, understanding the channels through which political information gets incorporated into stock prices is important for the design of the legal arrangements governing the flow of political information. Also, from a political science perspective, the flow of political information can engender rent seeking by politicians. Since political information is of significant value to stock market participants, elected officials may use such information to derive personal benefits (e.g., in the form of campaign funds and revolving doors). Also, since elected officials possess valuable information about their own actions, there is a possibility that they may have an incentive to intervene excessively in economic activities or to institute temporary policy measures that have to be revisited time and again (e.g., federal tax code provisions set to expire in a few years) in order to create a demand for the information. Our findings indicate that the flow of political information, if left unregulated, may contribute to the problem of political corruption.

The full article is available for download here.


[1] Wall Street Journal, 2006. Hedge funds hire lobbyists to gather tips in Washington, December 8.
(go back)

[2] Business Week, 2005. Washington whispers to Wall Street. December 26.
(go back)

Both comments and trackbacks are currently closed.