It’s often said in financial markets that correlation does not mean causation. On some occasions, however, denying the causation seems so outlandish to be, frankly, preposterous. As a case in point, Institutional Investor (II) discovered a newly published academic work investigating the investment returns of SEC employees. It turns out those guys are surprisingly good.
According to II, employees at the Securities and Exchange Commission may benefit from divesting companies ahead of investigations, research shows.
Employees at the U.S. Securities and Exchange Commission earn investment returns similar to the insider traders they prosecute, according to new research from Columbia University and Arizona State University.
Why aren’t we surprised. No matter, II continues...
A portfolio mimicking trades made by SEC employees between 2009 and 2011 earned excess risk-adjusted returns of about 4 percent a year for all securities, with abnormal gains jumping to 8.5 percent when only stocks of firms based and registered in the U.S. were tracked, found Shivaram Rajgopal, a professor of accounting and auditing at Columbia’s business school, and Roger White, an assistant professor at Arizona State University’s W.P. Carey School of Accountancy, in a paper published this month.
Rajgopal and White said the excess returns seemed to be primarily due to employees selling stocks ahead of bad news revelations. SEC employees, they explained, are required to divest their holdings in companies they are assigned to investigate.
“We are concerned that such a policy is tantamount to forcing employees to sell stock on non-public information given that virtually all investigations initiated by the SEC are private,” the authors wrote…
By comparison, a portfolio mimicking U.S. corporate insider trades earns lower risk-adjusted abnormal returns of about 6 percent a year, according to the research paper.
Hold on a minute…let’s recap.
SEC employees do twice as well by trading domestic stocks that happen to be located in their jurisdiction and the main source of these gains results from employees being forced to sell stocks they are investigating.
Firstly, we doubt there’s much “forcing” occurring. In fact, we’d love to be privy to some of the conversations around the inverse Chinese Walls water coolers at the SEC.
Secondly, are we meant to believe that, in general, individual SEC employees are running portfolios where performance benefits significantly from selling long positions in companies that, by a strange quirk of fate, they subsequently find themselves investigating?
Thirdly, when the report discusses selling, does that include shorting?
When II called, the SEC press department, the latter “didn’t immediately provide comment”. Probably nothing. Anyway, back to the report and II remarks on the difference in performance between buy and sell trades put on by the SEC’s trading gurus.
The study was based on trading data for 3,500 SEC employees provided by the regulator to the authors under a Freedom of Information Act request. Although these employees earned abnormal returns from selling stocks, Rajgopal and White said they “seem no different from naïve individual investors in terms of the securities they pick to buy” — suggesting excess returns were not the result of investment skill. “If SEC employees are simply good stock pickers, given their background and experience, we would expect to observe abnormal returns on their buys as well,” they wrote in the paper.
“Naïve” is something we suspect these people are not. But what do these seeming correlations mean? II comments on Shivaram and White’s conclusions.
Though Rajgopal and White acknowledge there is not sufficient evidence to conclude that abnormal returns are the result of SEC employees trading on non-public information, they argued that the current trading policy for employees should be reassessed. “Even an appearance of financial impropriety potentially undermines the credibility of the SEC with its stakeholders,” they wrote, suggesting that the issues they highlighted could be solved by prohibiting employees from trading in individual stocks. “While potentially draconian, such a policy is the simplest way to abrogate the concerns of even the most cynical observer,” they said.
So, there you have it, insufficient evidence of causation.