Insider Profits, Costs of Trading, and Market Efficiency
H. Nejat Seyhun
JFE 1986
Executive Summary:
This paper shows that insiders do beat the market but refutes previous work on insider trading that suggested that investors could earn abnormal returns by trading on the "news" of insider trading as reported in the SEC's Official Summary. Reasons for refutation: many of the trades were previously announced, previously studies had used CAPM to measure expected returns, and previously work had not considered the larger bid-ask spread that occurs as a result of insider trading.
This paper (which was part of Seyhun's dissertation at the UR) looks at previous work whereby an investor was purported to be able to earn abnormal returns by making the same trades as an insider when the SEC reported the insiders' previous trade. (The paper suggests that up to 2 months can take place between the insider's trade and the reporting of the trade in the Official Summary by the SEC.)
Data: looks at 790 firms (actually 769 since 21 reported no insider trading from 1975-1981).
Table 1 shows that insider BUYING was more prevalent at small firms (ratio of buys to sells was 2.09 vs a ratio at large firms of .59). This apparent trivia may be important in that the small firm effect would introduce a positive bias to any study using CAPM. To avoid this problem, Seyhun uses the market model.
As predicted the stocks where insiders sold had outperformed the market prior to the sales and where they bought the stock had underperformed (table 2) More interestingly there is a pronounced reversal around the trade date: this may be due to superior timing or the timing of other announcements.
Prior to investigating whether a profitable trading strategy exists, Seyhun points out that in the presence of insider trading, market makers will raise the bid-ask spread (see Stoll and Wahley 1983). Moreover, the bid-ask spread is more an issue at small firms.
Tables 4 and 5 are interesting (but difficult to understand). The author reports them to mean that all insiders are not equal. Notably, chairman and officer-directors have superior information than mere officers.
After adjusting the event date to the date the trade is first announced, abnormal profits to outsiders disappears. However, insiders do beat the market. That is, semistrong form market efficiency survives, but strong form does not.
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