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Wednesday 27 April 2011

Insider Trading – the Director’s Cut

Equivocable Insiders

Insider trading – the use of inside information about a corporation – to trade its stock to personal advantage is a major concern of regulators everywhere. Laws against this abound, and the penalties if found out are often significant: jail time awaits the unwary insider.

Of course, the ultimate insiders are company executives and there have been a lot of studies trying to figure out whether directors are any good at exploiting internal information. The evidence, such as it is, is equivocal and the reason seems to be that these privileged insiders don’t know as much as we think they do. Meanwhile insider trader laws are actually damaging the ability of markets to set prices efficiently: as ever, unintended consequences abound.

Director Deals, Darkly

Due to insider trading laws most company directors are subject to insider trading rules that prohibit them from trading lots of the time. In general they can only deal in their company’s stock after a corporate announcements, when all information is supposedly in the public domain. The idea, of course, is to ensure that all investors have a level playing field.

Despite the superstructure of regulation limiting the information that can be signalled through this channel investors still persist in following director trades in the belief that these flag future trends in share prices offering the opportunity to gain excess returns. Of course, something in this is irrational: either the regulation isn’t doing its job or people aren’t properly accounting for the insider information that the directors are revealing through their trades. Or, possibly, directors don’t have much of a clue about the future prospects of their companies and are as much in the dark as everyone else?

There’s a lot of research around director trading and it’s not at all conclusive one way or another. However, the general view seems to be that director trading does predict the future direction of the share price. As Friederich and Tonks report, in Directors’ Trades around Earnings Announcements on the London Stock Exchange:
“We find that even after adjusting for “round-trip” (spread) transaction costs, sizeable net cumulative abnormal returns remain at least for buy trades, and these excess returns are larger the sooner after the announcement the trade occurs”.
Director Timing

The idea is one we’ve seen before: that markets only adjust slowly to the information embedded in these announcements and, presumably, the subsequent director trades. Research from Australia suggests that the directors of smaller companies are generally pretty good at timing their trades, that outsiders react to these events but that the market is, again, slow to adjust.

When Lorie and Niederhoffer looked at this on the NYSE they also found short-term outperformance, especially if directors engaged in a series of trades in the same direction. Moreover, they also showed that:
“A change of direction of activity from purchase to sale, or vice versa, is of importance in deducing insider expectations”.
The overwhelming evidence, therefore, is that directors do have useful insider information, they do trade on this and if investors follow this information then they can make money, although the trading costs associated with such a policy make such a strategy far from easy to exploit. The signals are also relatively short-term in nature: which is not surprising as directors are reacting to short-term information. As this paper by Nixon, Roth and Saporoschenko relates:
“We find that very large, widely reported insider purchases do not forecast superior long-term share performance or superior long-term operating performance”.
Long-Term Laggards

In fact the evidence, such as it is, suggests that long-term performance gets worse in this situation. The researchers speculate that these share purchases are driven either by a need to demonstrate a commitment to the company or because the directors are trying to signal to investors that the company is undervalued. Of course, another explanation is that executives aren’t much good at investing.

So we have a general picture, that director trades are useful short-term trading signals but pretty useless for the long-term investor looking at a low trading strategy. For once this is a result that intuitively makes sense, although it’s far from certain that anyone building a trading strategy on this basis could actually make a living once costs are taken into account.

There’s a bigger question emerging from all of this, though, which is around the insider trading laws. The general idea of markets is that the more information they have the better they are at arriving at the proper price for the thing being traded. While you can see why regulators are concerned that insiders can distort markets to their benefit this has the unintended consequence of denying normal investors access to useful information: after all, if insiders can’t trade on the basis of inside information then this can’t be incorporated in the price.

Trading on Non-leaks

In fact, the situation is probably worse than this, because really price sensitive information tends to leak, leading to inexplicable price movements. This leads, inevitably, to the suspicion amongst any outsiders that any inexplicable price movements are caused by insider information which, by an inevitable set of psychological consequences, means that the unscrupulous can make money by causing price movements which cause other investors to think that there’s undisclosed inside information.

While we can probably agree that the Efficient Markets Hypothesis is a load of old hooey it’s also the case that if markets did behave more efficiently then society would be better off. There would be less uncertainty and therefore less causes of the kind of behaviourally induced panic that besets the markets from time to time. So having a bunch of laws that prevent information from being disclosed and which leads to less efficient markets in the name of fairness is a case of the biter bit.

Prediction Markets

Historically it’s the case that markets predict the future far better than the experts. As Robin Hanson points out in Insider Trading and the Prediction Markets:
“Orange juice futures improve on National Weather Service forecasts, horse race markets beat horse race experts, Oscar markets beat columnist forecasts, gas demand markets beat gas demand experts, stock markets beat the official NASA panel at identifying the company responsible for the Challenger accident, election markets beat national opinion polls and corporate sales markets beat official corporate forecasts”
Hanson makes the case that prediction markets can help companies run more efficiently internally, because they overcome the traditional barriers erected by middle managers who are reluctant to release information. This, of course, is part of the reason why director trades only give a partial picture: most executives only have a very limited view of what’s actually happening in their own companies.

Unintended Consquences

However, the development of this type of market is stymied because the availability of this type of information to a wide group of insiders – which is the point of the things – would almost inevitably lead to information leakage, which would breach insider trading laws. So we end up with laws which were intended to protect investors leading to their investments operating less efficiently and profitably. Meanwhile markets are more exposed to behavioral irrationality than they need be.

As a general rule, the more restrictions you place on the flow of information, the less efficient the associated markets and the weaker the associated signals. Insider trading laws unintentionally interfere with these signalling processes and open up other opportunities for the unscrupulous to make money. Quite how this particular circle is squared in a world in which trust is increasingly being replaced by regulation is a challenge, but it ought to be a priority for crash adverse regulators.

Related articles: Behavioral Law and Disorder, CEO Pay - Because They're Worth It?, Arbitraging Embeddedness

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