When you hear the phrase “insider trading’, you might automatically think of illegally exploiting non-public information for personal gain. But, depending on when they occur, insider trades can be perfectly legal. Senior executives, who often receive share options as part of their remuneration, buy and sell shares in the companies they work for fairly regularly. So what, if anything, do insider trades, and indeed non-trades, tell us about future returns? LARRY SWEDROE looks at the evidence.
Academic research has found that the trades, especially the buys, of corporate insiders provide information as to future returns, and also has identified when their trades are most informative. It has also found that insiders are typically contrarian traders: they buy value stocks, sell growth stocks and sell stocks with high short-term past returns.
In their recent, interesting study Trading Against the Grain: When Insiders Buy High and Sell Low, which appeared in the November 2019 issue of the Journal of Portfolio Management, Ruihai Li, Wesley Wang, Zhipeng Yan and Qunzi Zhang examined the trades of corporate insiders over the period 1986-2017. They sought to determine if insiders were susceptible to the same anchoring bias heuristic that individual retail investors have been shown to be subject to, and if their trades were informative as to future returns. Following is a summary of their findings:
Demonstrating anchoring bias, insider purchases as a percentage of all insider trades decreased almost monotonically as the stock price moved from far below the 52-week high to very close to the 52-week high. This pattern was robust to various measures of insider trading activity. The same anchoring bias was found on insider sales.
Insider trades made when stock prices are far from their anchor levels are more informative — when insiders trade against their anchoring bias, it is private information that provides the catalyst to overcome the bias. Purchases (sales) far from anchoring levels are made because the private information is positive (negative).
Returns were more negative following low sells than high sells, and returns were more positive following high buys than low buys. Because insider trades are public knowledge (since 2002 all insiders are required to report their trades within two business days after the transaction date), outside investors can reap abnormal returns by piggybacking on insiders who make these buy-high, sell-low trades, as purchases (sales) made far above (below) the anchoring price provide abnormal returns.
Consistent with prior literature findings that insider purchases are more informative than sales (sales can be made simply for diversification purposes), the return difference was more pronounced for insider purchases than for insider sales.
Subsequent 30-day stock returns following high buys using decile sorting were at least 3.3 percentage points higher than low buys. In contrast, the subsequent 30-day stock returns following low sells were at least 1.0 percentage point lower than after high sells. A long-short trading strategy — buy high and sell low — based on these findings generated an average monthly abnormal return of around 2 percent before transaction costs.
Results were highly significant and supported by various tests of robustness.
Their findings led Li, Wang, Yan and Zhang to conclude that the popular conventional wisdom of buying low and selling high makes investors, including insiders, easily subject to the anchoring bias. However, insiders also possess private information about their firms, which allows them to mitigate anchoring bias.
The study’s main contribution was to demonstrate when insider trades are most informative. When the stock price is far from its anchor level, stocks have more positive returns following insider purchases and more negative returns following insider sales. This is consistent with the notion that, in these cases, insiders have overcome their anchoring bias through their access to positive and negative private information, and trade precisely when the anchoring bias would suggest otherwise.
What about the non-trades?
An interesting question is: If insider trades provide information, do “non-trades” also provide information? To answer that question, Luke DeVault, Scott Cederburg and Kainan Wang, authors of the study Is ‘Not Trading’ Informative? Evidence from Corporate Insiders’ Portfolios, published in the first quarter 2022 issue of the Financial Analysts Journal, analyzed the actions of insiders who held multiple corporate directorships, seeking to determine if an insider trade of one stock reveals information about their other non-traded insider positions. Their data sample covered the period January 1997-November 2020. The trading strategies they examined purchased recently not-sold stocks following required insider sale disclosures and had holding periods of one, three, six or 12 months. Following is a summary of their findings:
Portfolio insiders profitably trade within their portfolio of inside holdings on average — bought stocks outperform not-bought stocks, and sold stocks underperform not-sold stocks (suggesting they consider private information when they trade).
The performance differences were primarily attributable to the large, positive abnormal returns of the not-sold stocks.
On average, not-sold stocks earn large abnormal returns following a portfolio insider’s sale. With a monthly holding period, the capital asset pricing model (CAPM) alpha of 47 basis points (bps) per month and the Carhart four-factor (beta, size, value and momentum) alpha of 53 bps were statistically significant at the 1 percent level. Performance remained relatively stable across the four holding-period lengths, with monthly alphas remaining at 44 bps and 42 bps for the CAPM and Carhart model, respectively, with an annual holding period—the abnormal profits are long-lasting.
Strategies survived transaction costs, especially at the one-year horizon because turnover was low.
Combining the trading strategies with momentum improved results — the strategy that bought stocks that were not sold and past winners outperformed the not-sold strategy and the past winners strategy.
Their findings led DeVault, Cederburg and Wang to conclude: “Insider sales reveal economically important information about the not-sold stocks that is not quickly incorporated into market prices.” They added that their results “suggest that even insider sales that are motivated by liquidity and diversification needs can provide value-relevant information about insider holdings”.
Finally the author noted: “The information content of insider buys is well known to practitioners and academics alike, and the market tends to react quickly to these transactions. In contrast, we find evidence of long-lasting abnormal returns for not-sold stocks, suggesting traders do not quickly incorporate the information from an insider sale about the not-sold stocks. The long-term nature of the positive performance suggests that a trading strategy of buying portfolio insiders’ not-sold stocks may be profitable for investors.”
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