To Find Insider Trading, Follow The Kids' Money

Apr 9, 2013
Originally published on April 9, 2013 7:14 am

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.

"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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Transcript

DAVID GREENE, HOST:

Government regulators at the Securities and Exchange Commission have recently made a big push to fight insider trading. This is the practice where people profit from illegal tips about internal news at a company. NPR's Shankhar Vendantam joins us regularly to share interesting new social science research and he tells us he's heard about an unusual way to spot insider trading. Shankhar, thanks for coming back to the program.

SHANKAR VEDANTAM, BYLINE: Happy to be here, David.

GREENE: OK. So what is this new technique? I understand it involves some travel to Finland.

(LAUGHTER)

VEDANTAM: That's right. So it's an analysis of trades made by a half a million investors in Finland over a 15-year period. Now, why Finland? Apparently, Finland offers researchers unusual amounts of access to information about who's making trades on the stock market.

I spoke with Paul Koch. He's a professor of finance at the University of Kansas. And along with Henk Berkman at Auckland University and Joakim Westerholm at the University of Sydney, they have a new study coming out in the Journal of Finance.

What they did was really simple. They divided these investors in Finland into groups: older adults, younger adults and even looked at accounts that belongs to children - obviously these recounts being managed by their guardians.

GREENE: OK.

VEDANTAM: Then they looked in which a set of accounts had the best stock market returns. And guess what they found? The accounts belonging to the youngest investors, the babies, blew everyone else out of the water.

PAUL KOCH: We were very surprised when we first found this evidence. Again, we were not looking for the result we found. The group from age zero to 10 seemed to outperform all the others.

GREENE: OK, hang on a second. We have kids who are age zero to 10 who are having the best returns. I assume it's not that they're just making really good investment choices compared to adults.

(LAUGHTER)

VEDANTAM: You know, one possibility is that all these kids are from Lake Woebegone, where we know the children above average.

(LAUGHTER)

GREENE: That's right, exactly.

VEDANTAM: But failing that explanation, it's the guardians of these kids who are obviously making these calls. And so, the researchers looked at what happened right before big company announcements, like mergers and takeovers announcements. And typically, there're huge stock swings, you know, right after a takeover announcement. What they found is that adult investors were right about 50 percent of the time right before a big takeover announcement, which is what you'd expect just by chance.

GREENE: Sure.

VEDANTAM: The kids' accounts were right 72 percent of the time. And that translated into a profit of 15 percent. And that's not 15 percent per year. It's 15 percent per day.

GREENE: A lot of money.

VEDANTAM: A lot of money. And the researchers then didn't stop there. They drilled down, they looked at the accounts that the guardians were running in their own adult accounts. And what they found is that when the guardians were operating their own adult accounts, the returns were not nearly as good as when they were running their children's accounts.

Koch told me this was a really big, bright red flag.

KOCH: Guardians are willing to trade on behalf of their children to earn these extraordinary returns. But they're reticent to trade through their account. One reason would be a fear of getting caught breaking an insider trading law.

GREENE: One reason, indeed. I mean I'm trying to follow the detective work here. But if you have kids who are making a lot more money, more successful trades, who are aged like two or three, you're starting to get suspicious that these guys are using their kids to make these insider trades.

(LAUGHTER)

VEDANTAM: Right, exactly. Now, Koch is a fisherman so he gave me a fishing analogy.

GREENE: OK.

VEDANTAM: He says that the Securities and Exchange Commission essentially has access to the kind of information that he was able to get on investors in Finland.

GREENE: We have as much information here as you do in Finland about these...

VEDANTAM: The SEC has access to that kind of information in the United States. Now, the challenge with going after insider trading is you often don't know where to look. And Koch says this technique can tell regulators where they can catch some fish.

KOCH: I found that the people who I know who are the best fishermen go where the fish are. And the regulators have their own fishing expedition. We would suggest that the age of the accountholder might point to a better place to catch some fish.

VEDANTAM: Now, one thing I should point out, David, is that people may think typically the SEC goes after the really big fish - they don't go after the minnows. And people may think that the guardians operating these baby accounts in Finland, you know, they're probably small investors. One of the interesting things that Koch finds is that it's the wealthiest investors in Finland, who are the most likely to be channeling these trades through the accounts of children.

GREENE: Interesting and I can just imagine these arguments in court, where investors are saying, Hey, Your Honor, no, no, no, no, no. My kids are just really smart - they're prodigies - that's why this happened.

VEDANTAM: It's only a question of time, David.

(LAUGHTER)

GREENE: I'm sure it is. Anyway, thanks so much, Shankar.

VEDANTAM: Thanks, David.

GREENE: Shankar Vedantam, he regularly joins us to talk about interesting social science research. You can follow him on Twitter @hiddenbrain. While you're at it, follow this program @nprinskeep, @nprgreene and @morningedition.

(SOUNDBITE OF MUSIC)

GREENE: And on a Tuesday, you're listening to MORNING EDITION, from NPR News. Transcript provided by NPR, Copyright NPR.