Insider Trading: My Perspective..

The recent arrest of Raj Rajaratnam, the founder of Galleon Group , a hedge fund, on charges of insider trading has generated responses from across the spectrum. At the one end, it is evoking the usual breast beating about insider trading and how unfair it is to the rest of us "non-inside" investors.
http://www.businessinsider.com/henry-blodget-moral-of-galleon-insider-trading-bust-only-fools-try-to-beat-the-street-2009-10
At the other, there are some who are pointing out that this case illustrates how ineffective insider trading laws are and that they should perhaps be abandoned.
http://online.wsj.com/article/SB10001424052748704224004574489324091790350.html
It is clearly a good time to offer my perspective on insider trading:

1. What is insider trading?
In it's most general form, insider trading refers to some investors trading on "proprietary information" that is not available to the rest of the market. The legal definition of insider trading, though, is a little more difficult to nail down. In the United States, insiders (managers of companies, directors etc.) are allowed to trade, as long at they meet two requirements:
a. They do not trade ahead of information events - acquisitions and earnings announcements, for instance - where they have access to the information prior to the rest of the world.
b. They report their trades to the SEC in filings.

Put another way, it is not illegal for a CEO or directors in a company to buy stock in the company, if they feel that it is under valued on a long term basis, even if that feeling is based upon information that only they have access to (project details). It is illegal for them to buy stock just before an acquisition or a big positive earnings surprise.

Looking at the allegations about Galleon, it seems clear that if the stories are true, the firm clearly broke insider trading laws by trying to get access to information about acquisitions, earnings announcements and other forbidden event-based information.

2. Does insider trading pay off?
Interesting question! At first sight, the answer seems to be obvious. Insiders know far more about the company than we do and should be able to leverage the information advantage into excess returns. The evidence, though, is surprisingly inconclusive. Studies that have looked at insider buying and selling as predictors of future stock prices find only a weak correlation, i,e., insider buying (selling) is not that good a predictor of stock price increases (decreases) in future periods.

One caveat about these studies is that they focus on the insider filings with the SEC. To the extent that the real insiders, i.e., the ones who are trading on real information rather than perception of value, will never register with the SEC, the suspicion is that these insiders make huge profits on their information.

Since Galleon is in the news, I decided to take a look at the returns that Galleon has made in recent years to see if they were able to convert their "illegal inside" information to higher returns. The Galleon Diversified fund, the flagship for the hedge fund, was up 22% this year, but is down 18% since its peak. Given the market performance over the period, the fund ranks close to the average. Across time, it is possible that Galleon made money using its access to "tips" from its moles in companies, but that does not seem to have generated a huge return.

I do not find it surprising. When you rely on tips from "insiders" for your investments, you generally find that four out of five tips never pan out (either because the information is bad or because the market reaction to the information does not follow the script), even when they come from those supposedly in the know. Insider trading is not a sure bet; it may not even be a good bet.

3. What should we do about insider trading?
I would like to live in a world where all investors have the same access to information and but I would also like to be able to go one-on-one against Lebron James. Life is not fair and investor access to information will vary across investors.

To me, the line between insider trading and savvy investing is a very hazy one, especially if you a short term investor. Analysts and investors often step across the line without even realizing they have.
http://www.nytimes.com/2009/10/20/business/20insider.html

I also think that banning insider trading is akin to laws forbidding alcohol or drugs. It does not make the problem go away but instead drives it underground and essentially leaves the profits from insider trading to those who are most unscrupulous among us.

I would suggest that we eliminate or at least reduce insider trading laws & restrictions and increase the transparency of the trading process. If you are trading on inside information but people can see you trading (and whether you are buying or selling), the benefits you will get will be time limited. Not only will this reduce profits from insider trading but also speed up how quickly prices adjust to information.

As a final note, insider trading cases provide excuses for the rest of us, who fail in our investing objectives. I have heard many small investors complain: "The reason I am not making any money on my portfolio is because the game is fixed." Enough of the self pity. The reality is that if your portfolio has lost money, insider trading is way down the list in terms of factors that caused those losses. In fact, my advice to those who worry about insider trading is simple. Trade as infrequently as you can and base your decisions on intrinsic value. Insiders hurt you only when you play their game, which is to try to trade short term on news (or what you think is news...) and rumors...