To Find Insider Trading, Follow The Kids' Money

Published On : 4/9/2013 7:00 AM
By : Shankar Vedantam
From : NPR
Categories : Nation, Business
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In New York and Washington, government regulators are cracking down on insider trading, the illegal practice in which people with internal information about important company events make stock market trades before ordinary investors find out what's happening.

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In New York and Washington, government regulators are cracking down on insider trading, the illegal practice in which people with internal information about important company events make stock market trades before ordinary investors find out what's happening.

In recent months, regulators have launched a series of high-profile arrests and investigations. Even Congress has gotten into the spirit of things, voting to ban insider trading by members.

Now, social scientists are muscling in on the action, too.

In a new study accepted for publication in the Journal of Finance, Henk Berkman at the University of Auckland, Paul Koch at the University of Kansas and Joakim Westerholm at the University of Sydney have uncovered a novel way to spot insider trading.

The researchers tracked half a million stock market accounts over a 15-year period between 1995 and 2010. The accounts were in Finland on the Nasdaq OMX Helsinki Exchange. Why Finland? It offered researchers unusual access to information about trades and information about investors, including their age.

To their surprise, when the researchers analyzed the data according to investor age, the accounts belonging to the youngest children blew all the others out of the water in terms of performance.

"We were very surprised when we first found this evidence," Koch said. "Again, we were not looking for the result we found. The group [of accounts belonging to children between the ages of zero and 10 years old] seemed to outperform all the others."

Koch isn't implying that babies know how to make the right picks in the stock market. The people operating these children's accounts were their parents and guardians.

How They Did It

Exactly how the researchers made the connection between a child's account and the guardian's without knowing either person's name — and without violating Finnish confidentiality laws — is an interesting bit of sleuthing on its own. First they got data about individual accounts that had the same last name, Koch says, but without being told what the actual names were. They next looked to make sure the pair of accounts had the same ZIP code, and that trades of the same stocks were made on the same day, and in the same buy/sell direction in both accounts. Only then would the researchers assume that transactions in both accounts might be being guided by the same person.

"We find that underaged account holders exhibit superior stock-picking skills on both the buy side and the sell side over the days immediately following trades," Koch and his colleagues report in their study. Accounts belonging to children (and managed by their guardians) appeared to be especially prescient when it came to major company events such as merger or takeover announcements.

"Since this outperformance is especially evident for short horizons," the researchers write, "it likely stems from superior private information that is about to become public."

Think about takeover announcements: Typically, these announcements cause large stock market swings. The researchers found that adults made the right calls about 50 percent of the time before a takeover announcement — what you'd expect in a world where people don't have special expertise or information.

The accounts belonging to kids made trades in the right direction 72 percent of the time after takeover announcements. Koch says this produced a post-takeover return of 12 percent. (That isn't 12 percent per year. It's 12 percent per day.)

When the researchers drilled down further, they found something really interesting: The guardians of these kids who were making these spectacular calls weren't nearly as successful when they made investments through their own accounts.

"Guardians are willing to trade on behalf of their children to earn these extraordinary returns, but they are reticent to trade through their own account," Koch says. "One reason would be a fear of getting caught breaking an insider-trading law."

Koch said that the results suggested that regulators who want to track insider trading might want to pay close attention to high-performing accounts belonging to underaged children. It's not that every profitable account the scientists identified was involved in insider trading — one would expect roughly half the guardians to make the right call just by chance. But as a group, these underage accounts did much better than chance would predict.

I asked Koch whether his findings from Finland were applicable to the United States. He said they were — and that, while information about trades and traders might not be as readily accessible to researchers, they were likely available to the Securities and Exchange Commission, which investigates violations and enforces insider trading laws.

Koch says regulators have expressed interest in his findings.

"I've found that the people who I know are the best fishermen go where the fish are," he says. "And the regulators have their own fishing expedition. We would suggest that the age of the account holder might point to a better place to catch some fish."

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