Decoding Inside Information

A portfolio strategy that focuses solely on opportunistic insider trades yields value-weight abnormal returns of 82 basis points per month.

Corporate insiders are a unique and potentially valuable class of securities traders to study because they have access to private information about their firms. In Decoding Inside Information (NBER Working Paper No. 16454), authors Lauren Cohen, Christopher Malloy, and Lukasz Pomorski note that, although they possess private information, insiders trade securities for many reasons, some of which are unrelated to such information. The authors find that more than half of total insider trades are "routine" and therefore not informative about the associated firm's future prospects. The remaining trades, however, are "opportunistic"; they are information-rich and have predictive power for the firm's future performance. The authors estimate that a portfolio strategy that focuses solely on opportunistic insider trades yields value-weight abnormal returns of 82 basis points per month, while the abnormal returns associated with routine trades are essentially zero. Further, opportunistic trades predict future news and events at a firm level, while routine trades do not.

Cohen and his co-authors develop a framework for classifying trades by insiders as "routine" or "opportunistic" based on a variety of attributes, including when the trade takes place during the year and whether the relevant insider has a history of similar past trades. The data on insider trades used in this study are drawn from the Thomson Reuters insider filings database and cover the period January 1986 to December 2007. The Securities and Exchange Commission requires that open-market trades by corporate insiders be reported within 10 days after the end of month in which they took place. Corporate insiders are defined as officers with decision making authority over the operations of the firm, all board members, and beneficial owners of more than 10 percent of a company's stock.

This study finds that the more opportunistic buys or sells identified for a given firm, the greater is the subsequent positive or negative effect on returns. By contrast, the authors find no relationship between the number of routine trades and future returns. Also, the researchers find that opportunistic traders decrease their trading activity in the wake of increases in the number of news releases by the SEC regarding illegal insider trading cases. That is consistent with opportunistic traders being sensitive to the potential costs of illegal insider trading.

Finally, the authors find evidence that some classes of opportunistic insiders make trades that are especially informative for future information events. Collectively, the results of this study suggest that it is possible to identify, out of the tens of thousands of insider trades made each year, which trades are more likely to be opportunistic and informative. More generally, the authors suggest that decoding the true information in other activities in the market, such as the trades made by banks or institutional investors, could help price-setters, market regulators, and all active participants in securities markets to develop a clearer picture of the information environment that helps form asset prices.

-- Lester Picker