January 13, 2016 / 10:23 PM / 4 years ago

SAFT ON WEALTH-Getting rich the insider way, in Congress: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

Jan 13 (Reuters) - Just as the best way to make money in gambling is to own a casino, so it seems the best way to outperform as an investor is to get elected to Congress.

And between 2004-2010 the best kind of member of Congress to be, at least in terms of investment performance, was a powerful Republican with an important committee assignment.

A newly revised study shows massive, persistent and troubling outperformance in the stock trades of members of Congress, a set of data which its author believes points to trading on inside information.

"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," Serkan Karadas, an economist at Sewanee: The University of the South, writes in the study. (here)

The study, which looked at almost 62,000 trades made by members of Congress in 2004-2010, found outperformance of 22.13 to 24.16 percentage points under a one-week holding period on an annual basis.

That short-term outperformance is significant, implying that the politicians were trading on time-sensitive information.

Powerful Republicans, defined as those with appointments to the 10 most important committees in the House or Senate, did best of all, outperforming the market by 32 to 36 percentage points under a one-week holding period annualized.

This kind of outperformance persisted even after Republicans lost control of Congress in 2006, while Democrats earned mediocre returns even in periods when that party was in control.

Make of that what you will, but it is unclear if the effects shown are driven more by power, information and access rather than better ethics in any particular party.

“The mediocre performance of Democrats’ portfolios is quite different from their superior performance in the earlier time periods. We argue that this is due to long-term control of Congress and the network effect,” Karadas writes.

The theory here is that the longer a party controls Congress the greater is the flow of information which might be exploitable through a trade.

The study showed only “very weak evidence” of what it calls “informed trading” for non-powerful members of Congress.

STOCK ACT

To explore the impact of relative power while in Congress on stock trading, the study looked at 50 powerful Republicans whose status shifted from having a powerful committee assignment to not having one. The results were striking: these 50 members traded almost five times more when they were in power compared to when they were not. Their performance was also vastly better while in the inner circle: abnormal excess returns were above 30 percentage points annualized for under one-week holding periods while in power. While out of power the same group showed “some evidence of underperformance.”

Earlier studies have looked at congressional stock trading with differing methodologies and mixed results. A 2004 study found strong outperformance during the 1994-1998 period, while one in 2013, covering 2004-2008, did not. This study uses different methods, and purports to be the first to look at the joint impact of party membership and powerful committee assignments on portfolio performance.

To be sure, implying something is not proving it, but these results give cause for concern that public officials were using their position for personal gain in unethical or unsavory ways.

And while the study attempted to control for the sophistication of the member of Congress making the trades, there is no way to completely rule out that outperformance was a matter of luck or skill, persistent as the outperformance was.

Concern over potential insider trading by members of Congress was the backdrop for the passage of the Stop Trading On Congressional Knowledge (STOCK) Act of 2012 which prohibits the use of non-public information for private profit and tightened reporting requirements. It remains to be seen, of course, if we will see members’ performance revert to the mean, much less if senators and representatives will now trade less frequently.

The STOCK Act, however, does not explicitly address the legality of members trading on non-public information they are given from sources outside Congress, a clear weakness of the legislation and something the study found evidence was occurring. People do, after all, want to put powerful politicians under an obligation, and what more effective way than giving them some profitable information.

The study both justifies the passage of the STOCK Act and suggests the need for even more transparency in congressional stock trading with easier access to data.

A Congress whose members abuse their position to profit in capital markets undermines both Congress and the capital markets themselves. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)

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