How profitable is insider trading, anyway?

October 20, 2014, 5:25 PM UTC
Former SAC Capital Portfolio Manager Mathew Martoma Sentencing On Insider Trading
Mathew Martoma, a former SAC Capital Advisors LP fund manager, exits federal court after sentencing in New York, on Monday, Sept. 8, 2014. Photographer: Peter Foley/Bloomberg *** Local Caption ***
Photo by Peter Foley—Bloomberg via Getty Images

It recent years, it seems like another high-profile insider trading case finds its way into the headlines every few months or so.

U.S. Attorney Preet Bharara—who patrols the Southern District of New York—has made stamping out insider trading a priority. So why, after years of news of stiff sentences for offenders, are new fraudsters cropping up, risking years in prison?

The answer: insider trading is insanely profitable.

In a new analysis by Kenneth R. Ahern of the University of Southern California School of Business, the median investor bets $200,000 on the basis of an illegal tip, and reaps $72,000 on that trade, a healthy gain of about 35%. Not bad, when you consider the average holding period is just 21 days. And while that might not seem like much considering that the S&P 500 picked up roughly 30% last year, these investments are usually pretty risk free.

Investors earn much, much more when they have inside information gleaned from clinical trials. These insider investments reap an average gain of 101% in just nine trading days, according to Ahern. This is precisely the type of trade that put former SAC Capital portfolio manager Mathew Martoma behind bars for nine years and forced him to give up much of the wealth he had accumulated over the years as a successful trader. In that case, Martoma was tipped off by Sid Gilman, an expert on Alzheimer’s who was privy to inside information about a drug being developed by pharmaceutical companies Elan and Wyeth. SAC reaped $275 million shorting stocks in Elan and Wyeth after Martoma learned through Gilman that an anticipated trial for the drug did not go as well as expected.

Ahern also examined the profile of typical inside traders. In his study, which tracked inside trading cases spanning from 1996 to 2013, he found that the average culprit is a 43-year-old man who is “among the wealthiest in the nation.” Only about 10% of inside traders are women, but when women do engage in this sort of behavior, they tend to receive tips from other women. Studying these networks, Ahern found that, just like traditional organized crime groups, inside trading rings tend to be closely linked by family and friendship ties, with 74% of insider pairs having known each other since childhood. People who are closer to the original leak of information also tend to earn higher returns, though they invest in smaller amounts, perhaps as a strategy to avoid detection.

The familial or family-like closeness within inside networks is one reason why law enforcement has increasingly been using mob-busting tactics to root out inside traders. In a recent article in The New Yorker, Patrick Radden Keefe writes that, when investigating SAC Capital, authorities used tactics like intimidating low-level employees with knowledge of their crimes and trying to get them to roll over on higher-ups. “The tactics echoed the approach the F.B.I. had used to dismantle the New York Mob,” Keefe writes. Unfortunately for law enforcement, sophisticated inside traders like those at SAC also used strategies not foreign to mobsters to avoid detection, like coded speech that renders intercepted phone calls and emails difficult to decipher.

Unlike much mafia activity, however, insider trading is seen by some as a victimless crime. It is certainly non-violent, which is one reason why law enforcement has taken a lax stance against it since it was first made illegal in the 1930s. But another main difference between the mafia and insider trading rings, as Ahern’s analysis shows, is that inside traders come from the upper strata of society. And, if nothing else, the recent assault against insider trading—with a rise in convictions and longer jail sentences handed down in recent years—is a sign that the wealthy can’t always expect to be given the benefit of the doubt by the law.

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