Can Anomalies Survive Insider Disagreements

This post first appeared on Alpha Architect Blog

What is the relationship between insider trades and anomalies?

• Anginer, Hoberg and Seyhun
• A version of the paper can be found here.
• Want to read our summaries of academic finance papers? Check out our Academic Research Insight category

What are the research questions?

Anomalies such as Value and Momentum have been exploited for years, yet the source of these premiums emerged as a major unresolved puzzle. Potential explanations can be grouped into two broad categories: “compensation for risk” or “mispricing”.

This paper studies this puzzle by investigating the relationship between insider trades and stock anomalies. Here’s a post about Insider trading pattern, from which we cite the definition of “Insiders”:

“Insiders” are broadly defined under SEC regulations to be those who have “access to non-public, material, insider information.” We perceive “Insiders” as more like officers who hold C-level positions in a company and usually can get access to information earlier than anyone else.

In other words, insiders are known as the investors best positioned to exploit mispricing of their own firm’s stock. This paper hypothesizes that if insider trades systematically predict the direction of returns due to anomalies, then it is likely that anomalies are due to mispricing/informational inefficiency.

To be specific, the paper examines the predictability of anomalies when insiders agree or disagree with the direction of returns implied by a given anomaly.

• AGREE: if i) insiders are ‘buyers’ of the stock and the anomaly signal predicts high returns, or ii) insiders are ‘sellers’ of the stock and the anomaly signal predicts low returns.
• DISAGREE: if i) insiders are ‘sellers’ of the stock and the anomaly signal predicts high returns, or ii) insiders are ‘buyers’ of the stock and the anomaly signal predicts low returns.
• NEUTRAL: if If insiders are not buyers or sellers.

The paper tests 13 anomalies:

1. Post-earnings announcement drift (PEAD) — Livnat and Mendenhall (2006)
2. Net operating assets — Hirshleifer, Hou, Teoh and Zhang (2004)
3. Gross Profitability — Novy-Marx (2013)
4. Return on assets —Fama and French (2008)
5. Investment in assets — Titman, Wei, and Xie (2004)
6. Assets growth — Cooper, Gulen, and Schill (2008)
7. Book-to-market — Fama and French (1993)
8. Net stock issuance — Pontiff and Woodgate (2008)
9. Bankruptcy prediction scores (Ohlson’s O-Score) — Ohlson (1980)
10. Accruals — Hirshleifer, Hou, Teoh, and Zhang (2004)
11. Composite equity issuance — Daniel and Titman(2006)
12. Size — Fama and French (1993)
13. Momentum — Jegadeesh and Titman (1993)

See the full post on Alpha Architect Blog:
https://alphaarchitect.com/2019/10/30/can-anomalies-survive-insider-disagreements/