Why Do Fund Managers Sometimes Resort To Insider Trading?

Firstly, a definition of what 'insider trading' is, is in order:

According to the Securities and Exchange Commission website, "'Illegal insider trading' refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.

"Insider trading violations may include 'tipping' such information, securities trading by the person(s) "tipped," and securities trading by those who misappropriate such information. Examples of insider trading cases that have been brought by the SEC are cases against: Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information."

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During the latter part of the last weekend, I read a riveting Behavioral Finance paper, authored by Messr. Jing Chen, that is entitled An Entropy Theory of Psychology and its Implication to Behavioral Finance. The paper struck me with an immense force of insight that changed the way in which I perceive insider trading.

In the paper Messr. Jing Chen asserts that "patterns in financial markets reflect the patterns of information processing by the investment public."

Generally, information is the reduction of entropy in a system, and all human activities are essentially entropy processes. Thus, this means that models from entropy theory, cast within a game theory framework, can be used to explain why hedge fund managers sometimes resort to insider trading.

Within the context of financial markets, the value of an information piece (to you) is a function of the probability that other market players, who have investment strategies that overlap with yours (and thus, are best positioned to replicate your portfolio positions), have accessed the alpha enhancing information piece before you.

According to the tenets of Information Theory, information satisfies the following properties (these properties are a verbatim quotation of a section of Jing's paper):

1. The information value of two events is higher than the value of each of them.
2. If two events are independent, the information value of the two events will be
   the sum of the two.
3. The information value of any event is non-negative.
   

The equation that best satisfies the above mentioned properties is Equation 1 below:

H(P) = -log_b P

Where b is greater than zero, and constant.

Equation 1 represents the level of uncertainty in an open system. When a signal is received from the environment, there is a reduction of uncertainty in the system, which, in essence, is the mathematical definition of information.

Now, let us suppose that a random event denoted by the letter X, has n discrete states, x1, x2, x3 …,xn; each discrete state has a corresponding discrete probability that expresses the likelihood of other market players discerning the respective state before you detect it. The probabilities are denoted by p1, p2,…,pn, respectively. (Note: Here I have departed from the syntax in Jing's paper to advance my assertion with clarity).

Therefore, the informational value of event X is the aggregate information value of each and every one of its discrete states. Thus, this gives us Equation 2 below:

H(X)=-/sum_{j=1}^{n}p_jlog(p_j)

The right hand side of Equation 2 is the entropy function first posited by Messr. Boltzmann in 1870s. This is the general form for information. (Shannon, 1948)

Therefore, If your adversaries were to understand the all the discrete states of an alpha enhancing information piece before you do, then all of the individual probabilities from p1 to pn =1. This means that when you plug the value (i.e 1 for each of the probabilities) into Equation 2 to compute the summation of the discrete probabilities, your end result will be: H(X) = 0. Therefore, this means that the information value of potentially profitable events already discerned by a fund manager's adversaries is zero.

Whereas, if a fund manager's adversaries fail to discern all of the discrete states of an alpha enhancing event, its information value is at its maximum. Thus, this implies that as pj approaches zero, the information value of an event tends towards a maximum.

The probability of other market players discerning alpha enhancing information increases as the number of market players (with strategies that overlap with your's) increases. Therefore if NMp is the number of market players, we can safely assert that as NMp increases pj approaches 1, and thus H(X) approches 0.

Thus, If we assume that fund managers are rational, profit maximizing individuals, we can conclude that they have an implicit incentive to trade on information that other fund managers don't have access to.

By definition, information that other fund managers don't have access to, does not exist in the public domain; it is privileged, sequestered and confidential information; and, acting on it is tantamount to insider trading. Otherwise put, trading on such information prejudices market outcomes in favor of a few, and undermines the credibility of the markets.

Hence, we can conclude that insider trading is an adaptive function that helps fund managers to outperform in forbidding market conditions, i.e. conditions in which crowding in strategies exists, and an environment in which replication of a fund manager's trades, by his/her adversaries, is rife.

Thus the answer to answer to the question: Why do fund managers engage in insider trading?, is; to survive.

Schedule 13D Filings Enable Trades to Become Profitable

From my very random weblog at: http://chirinda.tumblr.com/ (I write on a broader range of topics there, e.g. religion, climate change, sex, politics, and I post links to anything I like on the web, plus I also post a plethora of quotes that I find interesting. Please, run along now!) :-)

Note: I'm generally assuming that you know what a Schedule 13D filing is, and that you know what the form looks like and how the filing is made.

Generally, investors earn profits when events that precipitate in financial markets converge with the versions of reality that their trades are formulated to exploit.

Usually, it really doesn’t matter if the convergence is momentary, or sustained; it just has to happen within the envisaged time-frame for a trader’s P&L book to be in the black. (Yes, I know, that this sentence is naively structured, but I will clarify myself later. Please, keep reading.)

Managers of institutionalized capital pools are generally very jittery about making Schedule 13D filings, because they unearth their movements, which thus increases the likelihood of their strategies being imitated by their operational adversaries. Their concerns are not unfounded.

However, Schedule 13D filings may/can sometimes ignite trading patterns that force market events to converge with alpha traders’ anticipated versions of reality.

This usually occurs within an operational environment characterized by:

• High Volatility - When volatility is high, the market is more prone to overshooting in any direction. If it overshoots in the direction that the trader anticipates, the profits that can be reaped on any given trade are amplified greatly.
• Abnormally High Trend Following - In an environment of extreme trend following, the actions of market participants are motivated, not by fundamentals and rationality; they are motivated by ‘Chartism’ that is usually disconnected from fundamentals. In times like these, the markets may overreact to white noise, which may sometimes give birth to prolonged market swings that don’t make sense. When this happens, the gap between market events and reality increasingly widens.
• Strategies Being Affected By Capacity Constraints - When investment strategies are flooded by capital flows that the market cannot sustain, profitable trades become rarer, which makes market participants desperate and prone to irrational investing (gambling); and or, replication of the trades of alpha fund managers.

When alpha fund managers, of the stature of Messrs. George Soros and John Paulson, make Schedule 13D filings within a trading or operational environment that has all of the above-mentioned characteristics, they may/can be, in essence, unintentionally advertising their trading idea, or shepherding other market participants to replicate their trades.

Usually, other market participants will take this as a cue to replicate their trades, which in effect helps market events to converge with the realities envisaged by alpha fund managers. This accelerates the time it takes for trades to become profitable, and magnifies the profitability of a trade (provided that the alpha managers exit the trade before the market movement runs out of momentum).

Hence, it should be evident that Schedule 13D filings can benefit alpha fund managers.

Insider Trading is for Wussies; The Big Guns run Espionage Rings

"Actions speak louder than words"

- Old British Idiom

When Messr. Matthew Miller, a Bloomberg-Tv news anchor, was discussing the acquisition of 3Com (by Hewlett Packard) with his co-anchor (on Bloomberg-Tv's 11th of November 2009 edition of The Final Word), he asserted that the observed irregularities in the market activity, prior to the announcement of the said acquisition, reflected that insiders may have illegally exploited their informational advantage to reap small financial benefits from the transaction.

A few hours after he made this assertion, a blog post at Zero Hedge unequivocally corroborated his thesis.

For your information, the said Zero Hedge blog post states that:

• 3Com's acquisition by Hewlett Packard for $7.90 per share after the close today came as a surprise to many, but not all. Because someone bought three times the open interest in November $5 calls and fifteen times the open interest of the December calls. In summary: 3,961 November $5 calls were purchased today (964 open interest) for $0.65, as were 3,269 December $5 Calls (210 open interest) for $0.85. The profit, assuming the insider action was by one entity, is about $870,000 on the Novembers and $650,000 on the December strikes, for a not too shabby illegal daily P&L of $1.5 million

As Messr. Steven Levitt asserted in his bestseller entitled Freakonomics, numbers never lie, and the numbers in this case clearly show that an entity, or a consortium of entities, may have profited to the tune of USD1.5 million from inside information on the transaction. In short, insider trading may have transpired.

However, I am of the belief that people are rushing to conclusions prematurely; what usually appears at first sight to be insider trading, sometimes isn't insider trading.

Sometimes, information can be extracted from 'insiders' without their knowledge, using methods that are not really illegal or legal per se.

In scenarios like these, the trading activity that ensues such information harvesting activities has economic consequences, that like insider trading, undermine investor confidence in the fairness and integrity of the securities markets.

I'll cite a brief hypothetical example:

As you may already know, in every M&A transaction there is an investment bank that helps to structure the transaction, and a law-firm that lends its legal expertise to the parties involved in the integration process.

Most of the transactions that yield tremendous economic value are usually expedited by law firms and investment banks that dominate the upper echelons of M&A league tables.

Generally, Mergers and Acquisitions transactions are usually the culmination of months to a year of complex negotiations conducted in several meetings between the parties involved in the transaction. In most firms, senior partners and vice presidents in the M&A departments of investment banks are involved in the entire transaction.

Therefore, to get information on possible transactions before they get announced in the media, a hedge fund can engage several private investigators to track the movements of top M&A bankers and lawyers on a regular basis, and to just take note of whom they meet, the people in their entourages during the meetings, how long the meetings last, where the meetings are held, how often the meetings are conducted and e.t.c. .

The raw information can then be relayed to the hedge fund for processing, and basically the hedgie will tally-up the information and roughly categorize it as follows:

• Banker A, from such and such a firm met CEOs C and D in the presence of their CFOs and legal advisers, 4 times a week for the last 6 months, at 11am 90% of the time, at locations X, Y and Z. The meetings lasted an average of 4hrs 90% of the time. There is an M&A team from banker A's camp that is spending a total of 12hrs of week at the company that's managed by CEO D, and their visits usually coincide with those from the CFO and legal advisor of the company managed by CEO C. The company managed by CEO C is financially strong, whereas the company that is managed by CEO D is financially weak. Both companies operate in industries or sub-sectors that are mutually dependent, or symbiotic.

If you ask anyone who has ever been confronted with pictorial evidence of his infidelity by his wife, he will acknowledge that information can be gathered stealthy by private investigators. Thus, this means that most of the 'investigations', in the hypothetical scenario above, can be conducted without the subjects ever noticing that they are being tracked.

Hence, from the summary above, the hedge fund manager can ascertain, or infer, that the company represented by CEO C is in the process of acquiring the company managed by CEO D, and can then profit by shorting the shares of the company managed by CEO C, and going long on the stock of CEO D's company.

To obfuscate 'the trail', the hedge funds may use a combination of opaque OTC derivatives - to conceal the short portion of the trades; and, they may execute the long portion of the trade using low-latency trading systems that are so fast, that no one (from the outside) can tell that the transaction is transpiring.

The scenario above may seem like a fanciful suggestion, but ask yourself this question: why do most hedge funds have armies of private investigators on their 'unofficial' payrolls?