According to a recently revised academic study, U.S. hedge fund managers have clearly gained an information advantage from their connection with lobbyists, enabling them to generate excess returns. However, this advantage may have decreased significantly after the STOCK Act was signed into law in 2012.
Background of the Study
Over the past few years, legislators have been concerned about how hedge funds get access to and trade on nonpublic information from Washington DC that they obtain from lobbyists, boutique research firms, and others dealing in “political intelligence”.
Unfortunately, the opaque nature of the hedge fund industry has made this topic very difficult to study with any rigor – that is until the publication of a recent academic study called “Capitalizing on Capitol Hill: Informed Trading by Hedge Fund Managers”. The most recent draft of this study was published on July 25, 2014 by Jiekun Huang, Assistant Professor of Finance at the University of Illinois at Urbana Champaign and Meng Gao, also from the same institution.
This study examines the thesis that U.S. hedge fund managers obtain an informational advantage through their connections with lobbyists that help them generate excess returns on their trading of stocks that are highly impacted by government policy. Click below to download a copy of the paper:
Details of the Study
Mr. Huang and Ms. Gao used public lobbying disclosure data to identify which hedge funds had hired lobbyists. They assumed that hedge funds that hire lobbyists do so primarily to obtain private information about ongoing or impending government actions. They considered these funds to be “connected hedge funds”.
The authors also used lobby disclosures to determine which stocks might be most impacted by government policies by identifying the public companies that engaged most heavily in corporate lobbying. This was based on the assumption that companies whose operations and profitability are most impacted by government policies were most likely to try and influence government actions by actively engaging in lobbying. The authors called these “politically sensitive” stocks.
Leveraging a large dataset of hedge funds’ long-equity holdings, Huang and Gao measured whether connected hedge funds’ trading activity or performance in politically sensitive stocks were statistically different than the activity of non-connected funds when looking at their holdings of similar stocks.
The authors found evidence that, on average, connected funds’ trading volume in politically sensitive stocks account for 8.9% of their total trading volume, compared to 7.3% for non-connected funds. They also found that connected hedge funds earned abnormal returns of 63 to 86 basis points per month on their political holdings when compared to non-connected funds, suggesting that connected hedge funds possess an informational advantage in trading politically sensitive stocks.
Impact of the STOCK Act
The Stop Trading on Congressional Knowledge (STOCK) Act, signed into law in April 2012, has established a clear duty of trust and confidence for government officials, thus exposing hedge funds that trade on private political information to potential insider trading liability. Prior to passage of this act it was unclear what liability hedge funds had when trading on private information obtained from U.S. government employees.
Mr. Huang and Ms. Gao analyzed whether the passage of the STOCK Act had any impact on hedge funds’ performance in trading politically sensitive stocks. Consequently, they ran a test of the performance of connected hedge funds trading in politically sensitive stocks for the twelve months before and the 12 months after the enactment of the STOCK Act.
What the authors discovered was that connected hedge funds earned abnormal returns of between 59 and 96 basis points per month during the twelve months before the STOCK Act was passed. However, during the 12 months after the enactment of the STOCK Act, connected hedge funds generated statistically insignificant returns in their trading of politically sensitive stocks.
In other words, introducing a potential legal liability associated with trading on nonpublic political information due to passing the STOCK Act all but eliminated the benefits that hedge funds derived from obtaining this type of information from lobbyists.
When asked whether the study proved that Washington had eliminated the profit that hedge funds could generate from private political information, Professor Huang said, “That is an extremely tricky question. Based on our analysis, we conclude that connected hedge funds’ informational advantages in political stocks decreased significantly after the implementation of the STOCK Act. However, our tests do not suggest that the Act eliminated the profits from trading on private political information. The fact that we do not observe significant political outperformance for these funds after the STOCK Act may be because the Act truly eliminated the abnormal profits or because our tests are not powerful enough to detect such profits. More analysis needs to be done before we can conclude if additional legislative action needs to be taken to eliminate the informational advantage hedge funds gain from their interaction with lobbyists.”
Integrity’s View of This Study
In our view, this study was hampered by a few factors, including data limitations. Professor Huang was cognizant of this issue when he commented, “Both the political intelligence industry and the hedge fund industry are very opaque, which makes testing our thesis a challenge. We do not directly observe the information flow from lobbyists to hedge funds, nor do we observe hedge funds’ detailed transactions that are motivated by private political information. To obtain such detailed data, we would need to wiretap the communication between hedge fund managers and lobbyists like law enforcement does.”
Consequently, Huang and Gao relied on public disclosure of lobbying firms and used disclosed quarterly holdings of hedge funds. Because of a lack of data, they were not able to examine hedge funds’ use of independent policy research firms or investment banks that provide them with information or analysis on government policy developments. They also did not have good data on hedge funds short positions during the study period, because hedge funds are not required to disclose such information.
In addition, Huang and Gao relied on lobby disclosures to identify hedge funds that were obtaining private political information from lobbyists. However, lobbyists are only required to register an engagement under the LDA if they are specifically hired to try and influence government decisions on behalf of their clients. If a lobbyist concludes that their engagement with a hedge fund client does not qualify as lobbying (they are not trying to influence government decisions), then they may choose not to disclose this under the LDA. As a result, current LDA disclosures could significantly under estimate the instances when hedge funds hire lobbyists to provide them with private political information.
Lastly, Huang and Gao analyzed the impact of the STOCK Act over the first 12 months after it was passed. Could this impact have declined over time as hedge funds became more confident that regulators would not use it as a basis to try and charge hedge funds for insider trading? Of course, this issue could now be moot as the SEC is now in the midst of investigating up to 44 hedge funds for trading on nonpublic government information provided by independent research firm Height Securities.
Despite these issues, the team at Integrity Research felt that the recent study produced by Mr. Huang and Ms. Gao is an extremely unique and insightful one as it is the first time that anyone has attempted to rigorously analyze the benefits hedge funds obtain from hiring lobbyists to provide private information about potential government policy decisions. This study is also important in helping the public better understand how a piece of government legislation like the STOCK Act might have actually impacted the benefits that hedge funds derive from their relationship with lobbyists.