Hedge funds gain a performance advantage by being selective about which insider trades they mimic. In contrast, mutual funds, pension funds and other institutional investors tend to trade in the opposite direction of insiders.

Insider trading can be viewed as providing information, but not all insider trades are informative. Corporate executives and board members may make transactions for personal reasons such as raising cash or diversifying their portfolios. They may also trade in response to known but not necessarily public information about their company’s operations and “significant corporate events.” Trades made for the latter reason are considered to be informative.

Using a sample of U.S. stocks over the period 1995 to 2013, the study’s researchers differentiated between “opportunistic” and “routine” insider trades. These trades were defined based on the timing of transactions for a preceding three-year classification period. If insiders placed a trade in the same calendar month (during the classification period), those trades were considered to be routine. Opportunistic trades were those placed randomly in different months. During the period studied, insider trades were opportunistic approximately 45.1% of the time and routine 54.9% of the time.

Hedge funds showing the ability to differentiate between opportunistic and routine insider trades realized higher returns. The return advantage was realized when a hedge fund traded in the same direction as the opportunistic insiders for both buying and selling.

Mutual funds, pension funds and other institutional investors typically failed to make the same moves. Rather, they tended to trade in the opposite direction of insider trades without signs of differentiating between routine and opportunistic trades. This led to these investors providing liquidity—meaning a willing buyer or seller—to insiders who were seeking to trade.

The researchers concluded that hedge funds’ ability to identify informative insider trades makes them more skilled than other institutional investors. 

Source: “Are Hedge Funds More Skilled Than Other Institutional Investors? Evidence From Their Use of Insider Trading Information,” by Pouyan Foroughi, Jerry Parwada, Yixuan Rui and Jianfeng Shen; SSRN, November 2019.