Efficient Frontier
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William J. Bernstein

Insider Trading Drag

Every so often, if I’m lucky, I have an original idea. More often than not, however, I’m merely a translator, decoding financial jargon into plain English, trading off the fact that most financial economists can’t write their way out a paper bag. Once in awhile, a reader pitches me an idea that is so clever I just have to steal it. Such was the case a few months ago, when Joel Bickford, an investment advisor from Santa Rosa, CA, pointed out to me one of the perverse consequences of insider trading.

The average mutual-fund investor underperforms his mutual fund by buying high and selling low. For most fund investors, this amounts to about 4%-5% per year. The typical "hot fund" customer—your Janus or Van Wagoner investor—puts himself as much as 10%-20% behind the eight ball. More depressingly, even the average Vanguard or DFA investor loses about 1%-2% of traction per year. The data on hedge-fund investors is sketchier, but they don’t appear to do much better. However, someone out there is making excess profits.

Who, then, is taking the other side of these awful trades? Corporate insiders are the most likely suspects. This is actually consistent with the architecture of the efficient market hypothesis—after all, only its strong form, which has about as many believers as Saddam’s ex-information minister, excludes profiting from nonpublic information.

That said, benefiting from inside information is a tough row to hoe. Besides worrying about changing one’s wardrobe to an orange or striped motif, one must brave ferocious nonsystematic risk. Realistically, at any given time, one cannot be an insider in enough companies to obtain even a soupçon of diversification. Since the company involved is most often the perpetrator’s major source of income, unsystematic risk is yet further increased. While insider sales may lessen financial risk, they also greatly increase the chance of making their executor a guest of the state. Want to run a mutual fund, a hedge fund, or even a private portfolio based on inside information? Lotsa luck; you can cadge Ivan Boesky for advice on just how it's done.

Mr. Bickford’s particular insight is that the more clever a stock analyst, the more likely she is to take the other side of an insider’s trade. Let’s assume that on day zero, an efficiently priced stock is selling at $40 per share. Further assume that the next day, positive information about the company’s earnings prospects becomes available to, and only to, the company’s highest officers and were that information to become public, the stock would sell at $50 per share.

The insiders buy, but because of their limited trading power, the price rises only to $45. The perceptive analyst, who has done hundreds of hours of painstaking research, "knows" that the stock is only worth $40 and so sells—to the insiders. The noise trader, on the other hand, excited by the price rise, buys. When the information becomes public, the price rises to $50, benefiting both the insider and the noise trader, but hurting the analyst.

Such a scenario has two consequences. First, as has been noted by the behavioralists, the relatively slow, incomplete execution on information (both public and nonpublic) provides an underlying rationale for the momentum effect. And second, as suggested by Mr. Bickford, this "insider-trading drag" strikes hardest at the most competent, hard-working analysts, who are by definition most sensitive to deviations from fair value. Noise traders are benefited, and indexers are unaffected.

If this theory holds water, security analysis is not simply wasted effort, it is downright counterproductive, even without transactional costs. In such a hall-of-mirrors world, it may actually benefit the analyst to act opposite her best ideas, since the most persistent deviations from fair value may indicate the incomplete execution of insider trading. This dynamic holds only for those who trade individual securities; at the level of the entire market, there are no insiders. On rare occasions, when asset-class valuations do get out of hand in either direction, it is all the intelligent investor can do to simply stay the course. If he is possessed of extraordinary fortitude, allocations can be judiciously adjusted opposite to the era’s conventional wisdom.

For whom does the analytic bell toll? Only for those who understand which melodies contain useful information and what key they are in.

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