Company insiders with non-public information are using ETFs to conceal trades in a new kind of practice called ‘shadow trading’, a recent academic paper from the Stockholm School of Economics, University of Technology Sydney and Digital Finance CRC, has warned.
The research, titled Using ETFs to conceal insider trading, estimated insiders conducted $2.75bn of shadow trades using ETFs in the 13 years to 2021, an average of $212m a year, targeting companies with upcoming mergers and acquisitions (M&A) announcements.
Interestingly, these figures only reflect ETFs investing in US companies. They also only focus on trades front-running M&A activity and exclude other price-sensitive events such as company earnings, index rebalances and regulatory updates.
The true scale of ETFs’ role in insider trading may be far greater.
Over the sample period, researchers found “significant” levels of shadow trading in 3-6% of ETFs targeting the industries where relevant companies were involved, in the five days prior to the companies making M&A announcements.
“Whichever way we calculate them, our estimates of shadow trading are economically meaningful and suggest that a significant amount of shadow trading occurs in ETFs,” the research said.
“The abnormal pre-announcement ETF volume in the five-day period prior to the M&A announcement date is significantly larger in same-industry ETFs relative to ETFs in the control sample...with abnormal volume equal to 31% of the full sample standard deviation of abnormal volume.”
The evolution of ETF shadow trading
The authors argued ETFs are an “attractive instrument” for insider trading for several reasons. First, using an ETF containing their desired stock can be a more “subtle” route than trading shares directly, reducing the chance of being uncovered by law enforcement.
Researchers added ETFs are cost-effective baskets and often more liquid than their underlying, allowing insiders to maximise their profits while benefiting from the impact positive price-sensitive news might have on related companies.
These use cases appear to have resonated more over time with ETF-based insider trading rising in line with the “increasing popularity and liquidity of ETFs as an investment vehicle”, the research said.
In fact, while shadow trading occurred in 2-5% of relevant ETFs between 2009 and 2013, this range surged to between 7-14% from 2014 to 2019. In the six years to 2020, shadow trades in ETFs targeting US companies totalled $360m per year.
The paper added more than 80% of these trades occur in ETFs targeting health care, technology and industrials sectors, where insiders’ information advantage is more pronounced.
Unsurprisingly, the ETFs most targeted were those where target companies made up larger parts of their portfolio, or those where insider information is more impactful, such as small firms subject to M&A bids.
The top three products used in these shadow trades were the iShares Expanded Tech-Software Sector ETF (VIS), Vanguard Industrials ETF (VHT) and Vanguard Health Care ETF (IGV).
Taking the ETFs’ prices at the time of the research, average trading volume and the research’s findings on the prevalence of insider trading, the paper predicted a more representative view of the shadow trading taking place to be between $3bn and $9.6bn for IGV, $360m and $1.1bn for VIS and $800m to $2.5bn for VHT.
A new battleground against insider trading
Researchers said while the Securities and Exchange Commission (SEC) carried out its first prosecution for shadow trading in 2021, regulators and law enforcement agencies remain too focused on direct trading of company stock.
“If only the traditional, direct form of illegal insider trading is considered, then the total amount of insider trading may be underestimated as it fails to account for an economically meaningful amount of shadow trading,” the paper said.
“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.”
Kenneth Lamont, senior analyst for manager research, passive strategies, at Morningstar, told ETF Stream he was not surprised by the research’s findings but questioned whether ETFs would ever be the first tool of choice for this kind of illegal trading.
“ETFs, even at their sharpest, are a pretty blunt instrument and there are so many variables at play,” Lamont said. “Think about all the other stocks that are doing their own thing within an ETF; it is not an efficient tool to commit financial fraud in this context.
“Imagine you had Wirecard in the same basket as your stock that has earnings coming out. Potential positive outcomes are much less clear here. You are taking a lot of other risks doing this as a speculator with less than exemplary motives.”
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