Math doesn’t lie

The linked article from the New York Times purports to reveal how hedge fund managers are profiting from inside information (the term of art is “material nonpublic information”). In this case, the secrets refer to pending PIPES (private investment in public equities). If, as the article suggests, a pending PIPES deal is likely to cause a stock to drop, then a trader with advance knowledge should be able to take advantage of that information.

Here’s the money quote:

To be sure, not every PIPE causes a company’s stock to drop. Measured Markets, a Toronto research firm that looks for anomalies in stock trading, examined PIPE’s valued from $100 million to $250 million that companies on the Nasdaq or the American Stock Exchange issued in the first half of this year. Only half — 9 of 18 — had their shares drop in the 30 days leading up to the deals. (One of the company’s stocks stayed flat and the other eight rose.) Of those that fell, the average decline was 8.6 percent. Of those that rose, the average increase was 20 percent.

So, if we’re right and math doesn’t lie, what’s the value of this strategy? I bet $100 on each deal. I win $8.60 nine times, break even once, and lose $20 eight times? That’s a return of about $1800 + $77.40 – $160 = STUPID. Who needs to prosecute people for using inside information if this is actually what happens to them? The market is punishing enough.

Well, the NYT might say that these inside traders can reduce their exposure with options and margin and other things, but the fundamental nature of those numbers is that making all short bets is a loser, pure and simple. Unless this hypothetical trader can figure out which deals are going up and down, which was the point of the exercise, you have to be exposed the same on all of them. Maybe an investor will decide to hedge the downside, but that hedge has to cost money too, and so without specific evidence that it was possible at the time, we’re sticking with the simple math.

What’s the right question? Why does the NYT consider this story as proving anything, in spite of the plain calculations they present? All it does is highlight the question of why people don’t know this: most inside information isn’t. Rumors are already public knowledge by the time they get to you. Unless you start the rumor, it’s almost certainly not worth trading on (and then, of course, it is more plainly illegal market manipulation). The rationale that we find likely is that it makes hedge funds sound even worse to say that they are making money on the misfortune of others, since many people aren’t bothered by hedge funds making money when stocks go up.

What’s an even better question? Why not investigate the people who are betting that PIPES stocks will rise, since they’re making 20% returns on those bets! It makes us glad that we’ve become journalists looking for the story behind the story.

1 Comment

  1. […] So, to sum up, Morgenstern tells a half-truth, as far as the economic analysis goes, to drum up some fervor. She did a similar boo-boo when complaining about supposed insider trading on PIPES deals. The math for that one’s in an earlier post on showing your work in financial analysis. […]

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