Average investors face long odds of beating the markets consistently over the long term. In What Investors Really Want, Professor Meir Statman says that one of the reasons retail investors face these long odds is insider trading. According to one study quoted in the book, corporate insiders beat the markets by six percentage points each year on average. The same study also found that U.S. Senators beat the market by a Buffett-esque twelve percentage points annually. To be sure, most of the trading by insiders and Government officials is perfectly legal. But it isn’t always so.

Just last week, the Ontario Securities Commission alleged that a corporate lawyer passed along non-public information concerning pending corporate transactions to investment advisors who would in turn trade in the securities themselves and/or recommend the securities to family members, friends and clients. And investigators in the U.S. are in the midst of a major insider-trading investigation that is said to involve consultants, investment bankers, hedge funds, mutual funds and analysts. The current US probe comes just as the Galleon insider trading case, in which insiders at technology companies are alleged to have passed along material, non-public information to a hedge fund, is working its way through the courts.

Prof. Statman urges active investors to understand the good and bad news about insider trading:

But a false belief that the government is effective at preventing insider trading is costly to outsiders. The good news about the work of regulators in the United States is that they are largely effective at preventing insider trading. The bad news is that they leave the impression that they are more effective than they truly are, promoting unrealistic optimism among outside investors who are persuaded that the playing field is level when, in truth, it is tilted toward insiders.

This article has 24 comments

  1. Meir says: “The good news about the work of regulators in the United States is that they are largely effective at preventing insider trading.”

    I don’t think we can say that about Canadian regulators. Some international studies, as I recall, have found that Canada has one of the worse records for catching insider trading.

  2. I hadn’t really thought about insider trading being widespread enough to seriously affect active traders. Fortunately, insider trading affects honest investors in proportion to how much trading they do. That’s another good reason to avoid trading too much.

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  5. Does anyone have stats showing whether the problem in Canada is improving or getting worse?

  6. @Larry: I’m not so sure about the effectiveness of US regulators either. Here’s what the US attorney pursuing the latest insider trading investigation had to say:

    “Unfortunately, from what I can see from my vantage point as the U.S. Attorney here, illegal insider trading is rampant and may even be on the rise. And the people who are cheating the system include bad actors not only at Wall Street firms, but also at Main Street companies.”


    But, I agree with your point. We don’t even see as many investigations / convictions as in the US here.

    @Michael: I hadn’t thought of it that way either. But it makes a whole lot of sense. Corporate insiders who intimately know their company’s finances would definitely have an edge over outsiders. And their excess returns comes from the pockets of these outside investors. It offers one more reason to own a broad array of stocks and trade as little as possible.

    @Dale: No, I haven’t seen any Canadian studies. I haven’t seen US studies either. We only have the US attorney’s words that the problem is getting worse there.

  7. Come on, people! Anybody who watches stocks knows that it’s going on… Take any stock and look at how it trades the day before it reports either its quarterly performance or its some other surprise news item. Anybody who does their own trading knows that something fishy is going on nearly all of the time and it’s the same in both New York and Toronto.

  8. The Task Force To Modernize Securities Regulation in Canada found that the SEC fines for insider trading were 17 times higher than the OSC’s. Street is very short in Canada. No one wants to go after their friends or friend’s friends (see one Conrad Black).

  9. I disagree with Michael James; he touts ETfs, which will be subject, indirectly, to insider trading in the stocks held by the ETFs held by the investor. Holding forever, or frequent switching: in ETFs, mutual funds, or stocks would seem to put the investor at equal risk of insider trading over the long term.

    • @Dale: Not at all. The returns estimated for insiders are compared to benchmark returns. Passive investors, by definition, earn benchmark returns (less a smidgen in expenses). So where do the excess returns for insiders and Government officials come from? You guessed it. Other active investors who are on the other side of the trade from that of insiders and Government officials.

  10. I always find it difficult to comment on these stories when I can’t read the actual study.

    I wonder if this study includes all of the companies that went under where you better believe that the CxO’s and directors lost most of their (stock) fortunes (of course, losing 90% of a NW of 100M, you’re still in a relatively good spot).

    I also wonder if the study is just including their personal portfolios apart from their company stock compensation/purchase plans.

    Finally, I would like to see a standard deviation of the insiders. On “average” I might believe they win. But I bet a lot of them lose and a few of them win really really big.

    Again, this is all speculation unless someone has a link to the study.

  11. @Dale: An investor can only be harmed by insider trading if he or she trades against the insider. Just holding makes an investor immune unless there is some indirect trading. By indirect trading I mean such things as trading done by an index ETF when its index changes, or secondary offerings of stock by a company. These effects are quite small for a buy-and-hold low-cost index ETF investor. It is traders who lose out to insiders.

    As for my “touting” of ETFs, I try to be specific about low-cost index ETFs, and I’m open to hearing about other approaches. It’s just that these other approaches never seem to stand up to scrutiny.

  12. @Michael and CC Good points, but as Michael notes, ETFs (even idexes to a small extent) do trade in individual stocks — (if only to rebalance, from time to time) — and are therefore indirectly hurt, but only to a small extent.

    By the way, I too tout low cost index ETFs, though not exclusively.

  13. @ CC and Michael Upon second thought, aren’t most index ETFs and index mutual funds growing with new funds and investors? (Spurred on by both of you and me, and the growing legion who tout index products). To the extent that index-managers buy stocks to maintain their index weightings, I assume that when insiders dump stocks about to tank due to bad news, known only by the insiders, that our Index-ETF and index fund mangers buy from the bad guys, regardless of the price, and even after the knowlege becomes public or quasi-public. Doesn’t this dilute the the value of the investment of even the lonstanding holders of the inde fund or ETF.

    To the extent that active fund managers pay attention, wouldn’t they in theory know better, and help protect their investors?

  14. I have to agree with Phil S, I also notice that in many instances a news release is weighed and measured BEFORE it becomes public knowledge and usually when it is released it explains why the stock behaved the way i did. Unfortunately, I wouldn’t hold my breath waiting for this to be resolved.

  15. @Dale: The effect of insider trading when creating new ETF units depends on the method of creating the units. For the major ETFs that I’ve looked at, the creation mechanism is such that only those who are trading the ETF would be affected. This is because existing unit holders would continue to own the same number of shares in each stock held by the ETF. However, I haven’t spent enough time investigating to be fully confident in this assessment.

  16. @ Michael. I hope that you are correct. This is why I join in on these discussions; I often learn things. That said, I am probably worried about a pretty small problem, in the biiger scheme of things.

  17. @Dr. Dale: It is those taking the opposite side of the trades with insiders who are hurt the most. It is possible that there is some effect on those investing in broad market indexes but I’d guess that the effect is quite low. That’s because when you are purchasing a broad-market index, you are likely buying when some insiders are selling some stock but also when some insiders are buying their stock. Even if broad-market index fund investors are overpaying for their stocks, their costs are amortized over very long holding periods. I’ll agree that it is likely a very small problem for investors in broad-market funds.

    @Phil S, @Beating the Index: There are two problems with insider trading. One is perfectly legit but these trades can only be done in certain trading windows. Insiders cannot trade legally in the window leading up to an earnings release.

    But what about illegal insider trading? That’s certainly possible but it is a very difficult problem to measure. Is illegal insider trading rampant? Or is it just a few bad apples? I really don’t know.

    Then there is a whole other game going on with outsiders trying to figure out what earnings are going to look like. They probably talk to suppliers, check sales from other sources etc. All this is perfectly legal and the information gets baked into the stock price. This part of the effect may simply be due to how efficient markets are in processing information into the stock price.

    @DividendMan: This is a topic I’ve just started researching into. I’ll be sure to post all the research articles I come across.

  18. @ CC Is it possible that we actually agree on something? I’ll have to re-think everything. Cheers.

  19. With regards to studies of the effect of insider trading, Phil S pointed out an effect that has been studied and reported in academic journals. It was some time ago that I saw this article, but one study examined the price changes of stocks in the 2 weeks prior to announcements of being taken over. The authors compared Canadian securites to US securities. The US securities generally only showed signs of a ramp up in the last few days before the announcement and had a definite price spike at the announcement, whereas Canadian securities had a bigger and longer ramp up prior to the announcements than the US securities, and sometimes had almost no price spike. The hypothesis for this behavior is that in Canada the inside information is spreading farther and more people are able to act on it. As well, US companies are better at imposing and enforcing trading blackouts.

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