An email from a reader raised a very interesting question:
I was just at a local conference and saw a presentation on exchange traded funds. The paper examined whether there are differences in the adverse selection component of the bid-ask spread between three classes of securities: broadly diversified ETFs such as Spiders, more focused ETF (such as some of the industry sector ETFs companies like Barclays distribiute) and actively managed closed end funds. He found that the adverse selection costs are greatest for the closed-end funds, followed by those for the focused ETFs, followed by those for the closed-end funds.
A question arose during the presentation on the application of insider trading law to ETFs. Suppose Bill Gates had material non-public information about a critical shortage of microchips. Instead of trading in Intel stock, he chose instead to trade in an ETF composed of an index of 10 firms such as Intel and AMD. Would he be in violation of existing law?
I'm not aware of any SEC enforcement action on such facts. In theory, however, I suppose a case could be brought. Assuming Gates is not an insider of the ETF, the relevant theory of liability would be misappropriation of market information relevant to the price of the ETF. Rule 10b-5, which governs insider trading, applies to fraud in connection with the purchase or sale of "any security." Under the Supreme Court's decision in US v. O'Hagan, a fiduciary?s undisclosed use of information belonging to his principal, without disclosure of such use to the principal, for personal gain constitutes fraud in connection with the purchase or sale of a security and thus violates Rule 10b-5. If Gates had obtained the information from a source to whom he owes fiduciary duties (e.g., Microsoft) and he failed to dislcose his trades to Microsoft, liability presumably could follow.
For more on the misappropriation theory, check out my article In sider Trading: An Overview.
