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Not all trading by insiders is equally good at predicting share price moves.

It turns out that about half of all insider trades foretell future share price movements and the other half have little benefit.

The trick for investors is to figure out which trades to ignore, and which to track.



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Not all insider trades are created equal


MARTIN MITTELSTAEDT

From Tuesday's Globe and Mail

Oct 26, 2010


When it comes to trading, corporate insiders have a reputation for a deft touch, buying and selling at just the right times.

But it turns out that not all trading by insiders is equally good at predicting share price moves.

A trio of academic researchers – two from Harvard Business School and one from the University of Toronto’s Rotman School of Management – think they’ve discovered a simple way of parsing what insiders do that reveals which of their trades have the best chance of working out. The results of emulating the best trades were mouth-watering gains of more than 21 per cent a year.

It turns out that about half of all insider trades foretell future share price movements and the other half have little benefit, says Lukasz Pomorski, a Rotman finance professor. He is one of the researchers who’ve written a paper on their findings published through the University of Toronto.

“The contribution of the paper is that you can, quite simply, distinguish insider trades that are driven by information and are predictive about future prices from those that are made for other reasons,” Prof. Pomorski says.

The trick for investors is to figure out which trades to ignore, and which to track. Happily for ordinary investors, there is an easy way to distinguish between the two types, according to the study.

What the researchers found is that about half of insider trades have a routine quality about them. They are typically shares purchased shortly after a company grants its annual bonuses, or sold when a company makes its periodic share awards as incentive payments.

These trades occur the same month year in and year out, and don’t help copycat investors make money. It seems that when insiders make these moves they are mindlessly investing proceeds from incentive payments or just as mindlessly selling shares granted as compensation. The resultant buying and selling is not signalling anything about the underlying prospects for their companies.

The other type of insider trade, which the researchers dubbed “opportunistic,” is able to beat the market by a wide margin.

In these trades, insiders seem to be demonstrating their superior knowledge about their company’s prospects through such tactics as holding off on investing bonuses in advance of bad news or buying when they think good news is in the offing. These highly informative trades are made irregularly during the year and don’t follow any pattern.

The researchers analyzed publicly available data reported by U.S. insiders between 1989 and 2007. They placed trades that happened in the same calendar month at least three years in a row into one group, calling them “routine,” and then all the irregular trades, which they dubbed “opportunistic,” in another group.

Creating a portfolio of short sales and purchases equal-weighted to the opportunistic trades yielded 1.8 per cent a month, or over 21.6 per cent a year, while the researchers found the routine trades earned what their paper termed an “only marginally significant” return of 0.4 per cent a month.

The returns don’t include transaction costs, which could be significant because the insider activity generated a few hundred trading signals each month, requiring the portfolio to be rebalanced regularly.

The researchers also tracked corporate announcements to see whether the opportunistic insiders were on to something. They found that the buying or selling by the insiders was more likely to precede headline grabbing news events the month after the trade.

While sophisticated institutional investors with large amounts of cash could create portfolios to mimic the research paper, Prof. Pomorski says anyone can apply the basic findings to their own stocks or companies they’re interested in either buying or selling short.

Insider information is available on regulatory websites, where corporate executives and directors must divulge their activity. He says it would be easy for investors to track the pattern of insider activity by looking at whether trades are done at the same time each year or are irregular.

“One of the principles of our approach is that it’s really, really, simple,” he said.


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