- Insider traders have cooked up a new way to invest in stocks, according to researchers.
- They've poured nearly $3 billion into exchange-traded funds to avoid scrutiny from regulators.
- Their strategy isn't illegal in the US — but it might not be very profitable, either.
US insider traders have come up with a new way to avoid scrutiny from financial watchdogs, researchers said in a recent paper.
Investors with inside knowledge of deals poured $2.8 billion into exchange-traded funds that owned shares in their target companies between 2009 and 2021, academics based in Australia and Latvia found in their study.
Insiders aren't allowed to benefit by trading stocks if they have prior knowledge of a deal. But as it stands right now, there's nothing to stop them buying similar stocks, or ETFs that track the same sector.
So the new strategy isn't illegal yet — but it's probably not very profitable, either. Here's why.
Shadow trading
The academics, who analyzed 3,209 US-based merger and acquisition deals, say they've discovered a new type of "shadow trading".
Insider traders usually get caught when they, or their co-conspirators, buy a stock they have special knowledge about without declaring the trade to the Securities and Exchange Commission.
Rather than investing in the company they know about, shadow traders buy similar stocks — or in this case, ETFs that own the target stock — that might still benefit when news of a deal breaks.
"ETFs are not purely passive investment vehicles, they also play a role in insider-trading strategies," the researchers from the University of Technology Sydney and the Stockholm School of Economics in Riga said in the paper published this month.
"One can get a direct exposure to the company's share price via the ETF, but in a vehicle that is more subtle than trading the company shares directly, helping reduce scrutiny from law enforcement," they added.
It's worth noting that the transactions the academics analyzed had an average volume of just $212 million per year. That's a tiny sum in the ETF market, where $53 trillion worth of shares were traded last year, according to iShares.
But shadow trading is still an area of concern for the SEC.
Legal, but not profitable
So far, the US markets regulator has struggled to prove that shadow trading is illegal.
In 2021, the SEC lodged its first-ever shadow-trading charges against Matthew Panuwat, a director of the biopharma company Medivation.
The watchdog said Panuwat knowingly bought shares in a similar stock called Incyte just before news broke that Pfizer had agreed to take over Medivation. But its case is still dragging on in court.
Shadow trading ETFs is "a legal gray zone at the moment, until there is a precedent set in the courts" by Panuwat's case, the researchers said.
ETF providers aren't worried. They think it's unlikely that such traders are making a killing buying their funds, even if the SEC can't show that shadow trading is illegal.
Even the smallest ETFs own a basket of around 25 stocks, while the largest — like State Street's S&P 500 ETF Trust and iShares' Core S&P 500 ETF — have 500 in the portfolio.
The funds are so diluted that they probably won't get much of a bounce when a stock they hold rallies. That means shadow traders who invest in ETFs aren't likely to score the same gains as insider traders who bought an individual stock.
"In any basket trade, there are always winners and losers," Christian Magoon, CEO of ETF provider Amplify, told Insider. "An equal-weight portfolio of 25 securities, which would be a highly concentrated ETF portfolio, would see just 4% of its portfolio affected."
"Put another way, 96% of the portfolio may not be involved in the corporate action and in fact might suffer from it," he added.
In other words: the researchers say that they've identified a new, subtler form of insider trading, but don't expect ETF shadow trading to produce the next "Wolf of Wall Street" any time soon.