Insider trading transactions earn the typical insider less than $500 per year more than the average investor, according to an analysis of U.S. Securities and Exchange Commission data, with insiders who reside in the same state as the firm's headquarters even less likely to see high profits.
The study, published April 20 in Review of Finance, sought to measure the material benefits insiders might extract from their informational advantage, based on insider trading quantities and dollar profits, compared with the average investor. Previous empirical literature found high-percentage returns gained from publicly reported insider trades, but the researchers did not investigate the economic value of these transactions in dollar profits.
According to Peter Cziraki, the study's co-author and an assistant professor of economics at the University of Toronto, the percentage return of a transaction is unlikely to provide a meaningful and accurate picture of the transaction's economic value, as insider trades with high-percentage returns are likely to be smaller and less frequent than high-profit trades. Furthermore, both trade size and frequency can influence realized profit.
"To evaluate whether we can rely on percentage returns and make statements such as, 'Shareholders should be more worried about insider trading at firm A because insiders make 5% on their trades, whereas at firm B they only make 2%,' we thought it was useful to go back to the basic question of 'What do insiders care about?'" Cziraki told The Academic Times. "The simple answer is that they presumably care about how much money (i.e., dollars) they can make on their trades. Hence, we believe it is important to look exactly at this: the dollar profits to insider trading."
The researchers used data from a Thomson Reuters insider-transaction database, which consists of all transactions filed on the SEC's Form 4, for January 1983 through December 2013. In order to more accurately capture both frequent and infrequent insider trades, annual profits were compared rather than individual trades.
The median insider during this time frame earned abnormal dollar profits of $464 per year, and the average insider earned a total of $12,000 annually. Where compensation information was observable, insiders' trading profits were equivalent to just 0.1% of total compensation at the median and 1.1% on average. The study found that 7% of inside traders realized profits that exceeded 10% of their compensation, but this was not as common an occurrence as one might expect based on insiders' informational edge compared with "normal" traders.
In many cases, an insider would need to trade large amounts when abnormal returns are expected to be high in order to make high dollar profits. Cziraki noted, though, that dollar profits from insider trading are typically small because insiders with "the most informative trades" earn large abnormal returns, tend to trade infrequently "and in relatively modest amounts." In contrast, insiders who trade frequently earn lower-percentage returns per trade but still make higher dollar profits per year.
"We were surprised about a stark pattern when considering the relation between returns and profits: High abnormal returns are inversely correlated with trade size and trade frequency," Cziraki said. "This creates a wedge between returns and dollar profits. The insiders who make the largest [percentage] returns are not the insiders who make the largest profits."
In the study's sample, the average insider made seven trades, and the median insider made three, with actualized profits remaining small in both the near and long term. Local insiders, or those who reside in the state where the firm's headquarters is located, were less likely to make high dollar profits, according to the data, while blockholders, executives, CEOs and CFOs were significantly more likely to do so.
"Any insider trait that makes an insider put less emphasis on reputational losses or litigation risk would moderate how aggressively he or she trades, how large the volumes are that she puts to high-return trades," Cziraki said. For example, he added, local insiders may trade less aggressively because they have strong ties with the firm and are likely to be monitored more.
Since these findings further illuminate the extent to which insider trading actually benefits insiders, Cziraki and his co-author, Jasmin Gider, believe that profit insights could more precisely inform regulations and governance decisions made by corporations.
"Armed with this more precise measure, we think the literature is better equipped to examine which efforts to deter trading on information are effective (on part of firms or regulators), or the question of which policies are effective at which types of firms," Cziraki said.
Cziraki and Gider hope to see more research in this area "by academics in a wide range of disciplines, spanning finance, economics, law and accounting."
The study, "The dollar profits to insider trading," published April 20 in Review of Finance, was authored by Peter Cziraki, University of Toronto; and Jasmin Gider, Tilburg University.