Mimicking Insider Trading

Topics: Stock market, Expected return, Abnormal return Pages: 11 (3512 words) Published: September 15, 2014
Introduction
Much of the field of finance is focused on creating abnormal returns—that is to say, returns that are different from what one might expect them to be based on various characteristics of the investment—by identifying so-called “inefficiencies” in the stock market. Perhaps one of the most well-known strategies for taking advantage of these inefficiencies, a strategy widely discussed in academic as well as industry literature, is following the trades of company insiders. In the United States, company insiders are required to report to the SEC any time they engage in a purchase or sale of their firm’s stock, within two business days following the date of the trade. This information, once reported to the SEC, is subsequently made available to the public almost immediately, allowing outsiders to see exactly how insiders are trading. When insiders trade based on material non-public information and earn abnormal returns, it is a violation of the strong form of the Efficient Market Hypothesis, which itself is not backed by any significant empirical evidence. However, if outsiders are able to earn abnormal returns by mimicking insider trades, this becomes a violation of the widely-accepted semi-strong form of the Efficient Market Hypothesis, which states that the price of a stock incorporates all publicly available information. The academic literature contains many studies which attempt to generate excess returns by replicating insider trades, with varying degrees of success. While some early studies (Jaffe 1994, Finnerty 1996) claimed that outsiders were indeed able to create a small amount of excess returns, a later study by University of Michigan Professor H. Nejat Seyhun concluded that once these trades accounted for transaction costs, the excess returns would be nearly zero. Later studies by Rozeff and Zaman (1988), Lin and Howe (1990) and Friederich, Gregory, Matatko and Tonks (2002) have also reaffirmed that transaction costs depleted all the excess returns from these studies.(1)On the other hand, several studies conclude that it is possible to earn excess returns by applying a “mimicking strategy” selectively. For example, Lakonishok and Lee (2001) conclude that if an investor mimics only large trades and only by the top management of a company (excluding board members, majority shareholders and other company employees), an outsider could in fact generate excess returns. Other theories suggest that it is possible to successfully replicate insiders trades by using the strategy in markets outside the US, such as in the Italian, German and Spanish markets.[1]  A critical factor in determining whether an outsider will profit from replicating the trade of an insider is the motivation behind the trade. Insiders are likely to engage in insider trades for a number of reasons, not all of them connected to inside information on future firm performance. An inside trade that is motivated by liquidity or diversification needs is unlikely to contain any “predictive power” and result in any abnormal return for an outsider. While it’s relatively obvious that the insider’s motivation in making an inside trade is a key factor in determining how successful the outsider’s mimicking trades will be, existing academic literature has, for the most part, been unable to take advantage of this factor to increase returns on test portfolios. Were outsiders able to identify the motivation behind the insider’s trade, and filter out trades that are motivated solely by the insider’s personal needs, it might become possible to create a portfolio of performance-predicting trades, which would generate abnormal returns. In a 2007 paper entitled “Decoding Inside Information”, (Cohen et al.) Harvard University and University of Toronto professors test an innovative and original approach to mimicking insider trades. By using a simple algorithm, the strategy attempts to separate insider traders into two categories: opportunistic traders and routine...

References: (1)http://www.ukessays.com/dissertation/literature-review/empirical-analysis-of-legal-insider-trading.php
(2) Decoding Insider Information,  Lauren Cohen, Christopher Malloy and Lukasz Pomorski, March 23, 2010, P.15
(3) Investment Intelligence from Insider Trading, H. Nejat Seyhun, 1998, P.334
(4) Investment Intelligence from Insider Trading, H
(9) Historical Trends in Executive Compensation 1936-2005, Carola Frydman and Raven E. Saks, January 18, 2007
(10) http://gupea.ub.gu.se/bitstream/2077/36369/1/gupea_2077_36369_1.pdf
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