Do the rich get richer because they’re smart and hardworking? Or because money buys influence, connections, and inside information?
The Securities and Exchange Commission does its best to catch those who trade stocks on insider tips (just ask Martha Stewart and Mark Cuban), but its investigators can’t hope to make sure every trade by corporate insiders and their friends is kosher. A recent National Bureau of Economic Research study by Lauren Cohen and Christopher Malloy of the Harvard Business School and Lukasz Pomorski of the University of Toronto proposes a simple way of ferreting out suspicious insider trades. It also finds that mimicking these suspicious trades would allow you to beat the market by about 10 percent per year. This boost to returns may be enough to keep the privileged a little ahead of the rest of us. But the study itself may help erase the benefits of inside information by suggesting some statistical methods the SEC might employ to detect and punish insider trading.
Senior executives and other corporate insiders buy and sell shares in their own companies all the time. It’s all perfectly legal unless the trades exploit privileged information available only to a select few—insiders get a sneak preview of quarterly earnings and other announcements that have the potential to move markets, giving them a window in which to sell shares in their own companies in advance of a crash or buy stocks ahead of positive news. Due to concerns over the use of privileged information to profit at the expense of other investors (who naturally sit on the other side of the transaction), all insider trades need to be reported to the SEC and are made public.
Looking at the profitability of all insider trading might suggest that the SEC is already doing a pretty good job of keeping insiders honest: On average, the bets made by those in the know don’t do much better than the market overall. But as the authors of the new study observe, insiders buy and sell shares for many reasons. Some—Bill Gates, for instance—sell shares at consistent intervals precisely because they want the SEC to know they’re not up to any funny business. Others are similarly consistent in buying—executives often receive their bonus checks on the same date each year, and since they can often buy shares in their own company at a discount, they immediately convert their payouts into company stock. These two examples suggest a very simple rule for screening out “routine” trades that are unrelated to efforts to beat the market: Just get rid of all insider trades that take place at the same time, year after year. What’s left is the “opportunistic” trades that warrant a closer look. Of course, many of the trades the authors label as opportunistic could be perfectly innocent as well: The need for cash to cover the down payment on a new house, for example, could trigger a one-time trade that’s unrelated to a company’s future. The authors allow that any extra returns that they find, diluted as they are by such trades, probably underestimate the true value of inside information.
To assess the returns from insider trading, the authors collect SEC documents listing the trades of all insiders—senior executives, board members, shareholders with greater than 10 percent ownership of the company—between 1986 and 2007. They classify traders as “routine” if their purchases or sales fall on the same calendar month for at least three consecutive years in the past. They classify traders as “opportunistic” if their trades are not consistent or predictable in this way. (The authors also consider the possibility that insiders are sometimes routine and sometimes opportunistic, but adding this additional complication to their analyses doesn’t change things much.)
The authors then measure the trading profits of opportunistic and routine traders after controlling for factors like a stock’s riskiness and general market conditions at the time the trades take place. Routine traders don’t do any better than the average Joe depositing his monthly savings in a Vanguard indexed mutual fund. In fact, they do a little bit worse. The opportunistic ones beat Vanguard (i.e., the market average) by about 0.8 percent per month, which adds up to about 10 percent per year.
If opportunistic traders are selling their shares in anticipation of unpleasant surprises to the market (or buying in advance of positive news), then their inside trades should anticipate media reports that mention their company. The researchers downloaded 3 million newswire articles during the 1990s and linked the stories to their trading database to assess whether a company found itself in the headlines following insider sales or purchases. This was the case for opportunistic trades but not routine ones.
So should you be dialing your broker with instructions to mimic the trades of insiders that the study identifies as opportunistic? Insiders are required to report trades to the SEC within a couple of days of a transaction, so if you were closely following SEC filings you’d get almost the same boost to your portfolio as insiders. (Even if it took a little longer to get the information, you’d still make out pretty well—Cohen and his co-authors find that the superior performance of stocks purchased by insiders continues for months afterward.) You’d of course also need information on insiders going back a few years to figure out whether the trades you’re observing are routine or opportunistic. Probably not an option for the average day trader, but no problem for the Goldman Sachs and Morgan Stanleys of the world. But if enough investors were to act on the information in this study, all the buy orders would quickly drive up prices in response to opportunistic purchases, wiping away any benefit of following insider trades in the first place. (On the other hand, if the authors had kept their findings to themselves and used their formula to buy and sell stock, they might have profited handsomely from it.)
The insider himself—the one who gets to make the very first trade—still walks away with his extra 10 percent. However, by providing an effective means of screening out irrelevant insider actions, this exercise in “forensic economics” can help the SEC and other regulators focus their efforts where—statistically speaking—the likelihood of misconduct is greatest.