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Legislation affects stocks, both on a broad and industry specific level.

However, the market impact can be hard to figure out because it can be complicated and take some time to implement. So how would an investor go about trading it?

Lauren Cohen, Christopher Malloy, and Karl Diether take an extremely interesting approach to the question in a new NBER working paper.

The key is to focus on the behavior and incentives of specific legislators. Members of Congress have an interest in the success of the firms that employ people in their home district. The behavior of those legislators that have the greatest stakes versus those for whom the industry isn't important provides important information about a laws probable effect.

Legislator interest is determined by the number and size of firms in addition to the number of employees for a particular industry within a lawmaker's constituency.

They then look at whether interested legislators are more positive or negative about a particular bill compared to other uninterested voters. If they're more positive, the bill is marked as a favorable bill for an industry and vice versa.

Here were their results:

Using this simple method, we show that a long-short portfolio of industry returns in the month following the passage of a bill where we listen solely to vested interest legislators (i.e., long the affected industries when interested senators are especially positive about the bills passing, and short the affected industries when interested senators are especially negative about the bills passing), yields returns of 76 basis points per month. These returns are virtually unaffected by controls for known risk determinants. For example, the four-factor alpha of this long-short portfolio yields abnormal returns of 92 basis points (t=3.01) per month, or over 11 percent per year.

Refining the model provides even greater returns. Following interested legislators where the affected industry makes up a major portion of their state's activity yields abnormal returns of 105 basis points per month.

Following interested legislators affected by the most important industry in a given bill raises returns to 130 basis points per month, or 15.76 percent per year. Reducing the portfolio further to those firms that are headquartered in interested legislator states yields returns of 184 basis points per month.

Returns can be limited for heavily lobbied bills, as the difference between interested and uninterested legislators may be skewed by lobbyist spending.

Read the full paper here.

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