Insider trading has been a very attractive research area for the past 50 years. It used to be that when a study analyzed returns to insider trading, only small data samples were used. The use of computers to help with the analysis didn't come until later. One of the first studies that used the entire insider trading dataset was Josef Lakonishok and Inmoo Lee’s 2001 Review of Financial Studies paper. Korea born Inmoo Lee received his Ph.D. in 1995 from the University of Illinois at Urbana-Champaign. There, he became a student of behavioral finance icon Josef Lakonishok. Lee tried his hand in academia, but later decided to be a quant at Eugene Fama’s Dimensional Fund Advisors. Apparently being a student of Lakonishok's didn't hinder his chances at getting the Vice President of Research position at the “Efficient Markets Hypothesis” shop.
Josef Lakonishok has been doing behavioral finance research for more than 30 years. He is the second largest owner of LSV Asset Management. He is quite successful too, making tens of millions of dollars ever year. For more information about Lakonishok’s fund management experience, you can read our article titled Best Mutual Funds: LSV Value Equity Fund Returns and Alpha.
Lakonishok and Lee analyzed insider trading returns (see definition of insider trading) using all companies from 1975-1995. They also investigated aggregate insider trading as a signal for the direction of stock market indexes. Interestingly, aggregate insider trading can be used to predict the movements of stock market indexes. They calculated the ratio of purchases minus sales to total insider transactions for each month and then compared that ratio with the 59 other monthly ratios over the last 5 years. When the net purchase ratio was in the top quintile, that meant insiders were the most optimistic. Lakonishok and Lee found that the stock market increased an average 21.2% during the following 12 months when insiders were most optimistic. Whenthe net purchase ratio was in the bottom quintile, that meant insiders were the most pessimistic. The pair found that the stock market returned an average 8.1% during the following 12 month period. It's clear from this study that aggregate insider trading has some signaling power about the future direction of stock market.
Also in the study, Lakonishok and Lee found that firms with extensive insider purchases beat firms with extensive insider sales by 7.8% during the following 12 months. However, insider purchases are tilted towards small and high book-to-market companies whereas insider sales are tilted towards bigger and low book-to-market companies. That relationship affect the returns favorably. When we control for size and book-to-market effects, the abnormal returns drop to a still respectable 4.8%.
The other takeaway from Lakonishok and Lee’s study is that insider trading is more informative in smaller firms. As a result, investment strategies developed based on insider trading can manage small amounts (hundreds of millions instead of billions) profitably.