Inside and Outside Informed Trading

Abstract

We contrast the patterns of abnormal trading activity by two important groups of informed traders: inside (firm and its insiders) and outside arbitragers (hedge funds and short sellers). We find that net trading by firms (NFT) and outside arbitragers (NAT) both independently predict future stock returns despite their zero correlation. The return predictability of NFT is far more long-lasting compared to NAT. Moreover, NFT capitalizes on persistent anomaly signals, whereas NAT transient ones. These two types of traders exhibit opposite trading directions based on the two anomalies central to asset pricing: NFT (NAT) is on the right side of profitability (momentum). We find that the perplexing divergence between these two seemingly related anomalies can be attributed to their information availability and differing weights on the public information. Firms possess superior information about the persistence of their own profitability, while outsiders underestimate such persistence. Therefore, firms respond far more strongly to persistent profitability than transient profitability. We also find that NFT tends to focus heavily on valuation signals, which lead them to appear to trade against the momentum signals. In contrast, NAT places a lower weight on valuation, allowing them to profit from the momentum signal.

Keywords: Informed trading, Firms, Share issuance, Buybacks, Insiders, Outside arbitragers, Profitability, Momentum, Persistence in Profitability, Fundamental Valuation, Anomalies