The Boring Invstr - Your Simple, Digestible Weekly Investing & Finance Newsletter

Welcome Back to The Fourteenth Edition of The Boring Invstr!

I want to apologize for not releasing an edition last week. I did not plan my time well and did not want to provide a subpar edition.

Hello Boring Invstrs,

This week I analyzed a complex academic study on insider trading. Like myself, you may not be familiar with certain terms you may come across in this week’s edition.

Below are a Couple of Notes:

• Many academic research papers that focus on insider trading rely on intensive-trading criteria. Intensive trading criteria can widely range but focuses on the analysis of abnormal returns and classifies firms as purchases and sales. Contrarily, this study focuses on performance evaluation on value-weighted portfolios. In theory, they developed a mutual fund that is managed by all insiders. The larger insiders who hold the most stock hold a greater influence on the portfolio.

• The study was performed without a predefined intensive-trading rule providing a more accurate test of the hypothesis.

• Abnormal Returns = stocks return - return on value-weighted market (NYSE, AMEX, Nasdaq)

• Market Beta = measure of how an individual asset moves on average when the stock increases or decreases (a measure of volatility and risk)

Insider trading in the US is one of the most controversial but one of the least talked about topics outside of the world of finance. Many stalk high-level executives and politicians’ portfolio disclosures to find an information edge on the market. In 2003, Harvard University researchers Leslie A. Jeng, Andrew Metrick, and Richard Zeckhauser made it their mission to dissect the science, profit, and policy behind insider trading.

The study, which was published in the Journal of Finance, established two portfolios, a buy, and a sale portfolio. Trades for each portfolio were acquired or sold at closing prices on days of actual trades. Due to Rule 16b of the SEA, “The Short-Swing Rule,” each portfolio held all shares for 6 months. On the sell side, after a sold transaction occurred the sale portfolio would hold the stock for the next six months.

Using two different portfolios allowed Jeng, Metrick, and Zeckhauser to use performance-evaluation methods to measure abnormal returns.

Abnormal return is a term used to describe returns greater than the market average.

For reference, performance-evaluation methodology is an overcomplicated way to say they used common financial metrics such as transaction size, past returns, price-to-equity, and cash-flow-to-price to estimate returns from insider trades.

In the study, Jeng, Metrick, and Zeckhauser used three performance measures to measure abnormal returns.

1. Capital Asset Pricing Model (CAPM) - measures the relationship between risk and expected rate of return for an asset/investment.

2. Four-Factor Model - Imagine CAPM with two additional factors.

   ** Reference Mark Carhart’s addition to the Fama-French 3-Factor Model (1997)

   4 Factors:

   1. Risk

   2. Value

   3. Company Size

   4. Momentum

3. Characteristic-Selectivity Measure - Essentially, matches insider transactions with a portfolio of similar stocks and calculates an excess return relative to the portfolio daily.

While each measure obtains its own reputation in regard to academic and financial validity, each of the three was used to determine performance evaluation in its own way.

After using all three measures, researchers concluded that insiders earn larger abnormal returns from purchases by point estimates that range from 52 to 68 basis points or .52% to .68%.

Researchers also concluded on the sale side that all measures are small and statistically insignificant meaning it does not accrue abnormal returns.

If you are looking for a performance comparison, insider buying outperformed the market by 11.2% while insider selling showed a slight advantage of 0.3%. A third of this can be attributed to insiders purchasing small stocks, growth stocks, and stocks with higher market betas. Approximately a quarter of abnormal returns come within the first five days and approximately a half come within the first month.

The Specific Returns and Composition of Each Portfolio are Listed Below.

Purchase Portfolio:

• 26.3% annualized return (15.6% return for market)

• Consists of 34.3% growth stocks and 29.8% value stocks

Sale Portfolio:

• 15.9% annualized return (15.6% return for market)

• Consists of 54.1% growth stocks and 18.1% value stocks

Hypothetically, I want to start a mutual fund with my sole and main strategy being insider trading.

This is what I would consider based on the study…

1. The average monthly ratio of insider purchase probability compared to the market volume traded is much less when compared to sale probability compared to the market volume traded (NYSE, AMEX, and Nasdaq).

   Although insider purchases would statistically occur less I would still base my strategy on insider purchases. This would be my filter to take fewer positions leaning into the long-term game of not trading too much.

2. Utilize Cumulative Abnormal Returns (CAR).

   CAR is measured relative to the trading day by adding daily abnormal returns for all intervening days. Intervening days is any day in the 6 month hold period.

   In regard to the previous 100 days before an insider sale, CAR is positive (12%) before the trade and provides no noticeable effect after the sale.

   On the purchase side, CAR is -2% over the previous 100 days before the trade while the following 100 days provide a positive CAR of about 6%.

3. The Size of the Firm and High Executives Does Not Matter or Return Significantly Higher Abnormal Returns.

   Although lower volume purchases have smaller abnormal returns than higher volume purchases bigger firms and higher level executives can make, it is not a significant amount. I would also consider higher-level executives executing their options contracts.

4. Lean Into Warren Buffett’s Long-Term Mindset.

   In accordance with Rozeff and Zaman (1998) and Lakonishok and Lee (2001), insiders buy value stocks and sell fast-growing growth stocks. If insiders aren’t following Buffett’s long-term strategy to buy value stocks low, then I don’t know who is.

   Think about the recent market rally in technology stocks like Nvidia and Tesla. Although both definitely have room to grow as growth stocks, some investors may want to guarantee massive returns than not selling and seeing.

5. Realize Insider Trading is a Small Part of All Market Transactions.

   Insider transactions are only a small part of what goes on in the market. Insider purchases are even a smaller portion of that. If I were to take this strategy on, I would suffer from time lag.

   Insider trades can be informative but does not mean insider traders earn abnormal returns. Insider traders are not perfect. Outsiders are only slightly disadvantaged when selling and not disadvantaged when buying since insider trades are such a smaller proportion of all open market transactions.

Enough about what I took away, here is what the researchers want you to take away. The researchers approached their study in three ways:

1. Science of the Market - Market Efficiency

2. Profit From the Market - Develop Optimal Trading Strategies

3. Policy on Insider Trading - Is it Fair? Does it Generate Returns?

You should know that there are implications to finding market efficiency. After all, no one truly knows what happens next.

Profit is not guaranteed, even if you think you think you developed an optimal insider trading strategy.

Insider transactions affect insiders less than you think. Insider transactions are such a small portion of all market transactions.

That’s all for this week! I will be shifting towards more topics like this over the coming weeks. The link to the study is linked below.

Trey

Link to the study: https://scholar.harvard.edu/files/rzeckhauser/files/insider_trading.pdf