Academic research on the use of ETFs for insider trading could add one more item on the list of slippery ethical issues fund boards may be called on to oversee.
Traders with knowledge of upcoming mergers and acquisitions have used ETFs to mask insider trades worth a total of $2.75bn between 2009 and 2021, according to an academic paper posted. Feb. 1.
Analysis of 13 years’ worth of transaction data from U.S. ETFs and corporations during the five days before M&A announcements showed statistically notable upticks in the volume of trades at of ETFs that contain the target stock, according to the paper “Using ETFs to Conceal Insider Trading” by from researchers at the Stockholm School of Economics and the University of Technology, Sydney, which is available here in PDF form.
“These ETFs, which are the most likely to be traded by insiders if shadow trading does occur, have significantly higher levels of abnormal trading than various randomized control samples of other ETFs and other trading days,” according to the paper. “Our findings suggest insider trading is more pervasive than just the “direct” forms that have been the focus of research and enforcement to date.”
Buying shares in an ETF that includes a target stock is less obvious to regulators than buying shares in one of the target companies or in a related company that could get a bump from the news, researchers wrote. ETF shares are also more liquid and less expensive than buying shares directly and give insiders a chance to benefit from rises in both the target company and related companies, they said.
“Shadow” trades averaged about $212mln per year and involved an average of 3% to 6% of same-industry ETFs. More than 80% of the total dollar amount of shadow trades the researchers identified came from three industries – health care, technology and industrial sectors – where the number of ETFs involved averaged between 2% and 12%.
Researchers looked only at ETF investments related to M&A activity, not price-sensitive news events or announcements, because M&A activity tended to result in bigger changes in the price of shares than other events and was easier to examine in isolation from other potential price-changing influences than other news events.
“Our evidence indicates that ETFs are not purely passive investment vehicles, but they also play a role in insider trading strategies,” especially in health care, technology and industrial sectors “which is consistent with the higher levels of information asymmetry in those industries,” researchers warned.
The SEC has not publicly charged any ETF for involvement with insider-trading schemes but has pursued private-equity funds for misuse of non-public information and for failing to maintain policies that would prevent the misuse of non-public information by employees who also had oversight of investment decisions.
SEC chair Gary Gensler has also warned repeatedly that the agency would pursue transactions it considers fraudulent even if the structure of the investments involved doesn’t match existing regulations. He has also promised to quash investment schemes the SEC considers likely to harm investors without waiting until after the damage is done.
The SEC has pursued instances of shadow trading; however, the paper’s authors argue, citing the charges it filed in August, 2021 against an employee of pharmaceutical firm Medivation, Inc., who bought options in a third-party company that increased in value after the sale of Medivation to Pfizer, Inc. was announced.
That example “shows that regulators have started to monitor and enforce against shadow trading in related stocks,” researchers wrote. ” Our paper suggests law enforcement agencies should also investigate trading in other related securities such as ETFs.”
Shadow-trading charges would be directed primarily at investors buying shares based on non-public information; any regulation aimed at fund managers or directors would likely focus on monitoring and disclosure of investments that could indicate an effort at insider trading just as they are currently required to monitor potential instances of money laundering.
“From a legal perspective, it is worth considering how adequately current insider trading legislation and case law are equipped to take enforcement actions against the large amounts of shadow trading documented in ETFs,” the authors concluded.