Existing institutional investors have a lot of flexibility in terms of the selection of order types until their ownership crosses the 5% threshold mark. The authors’ empirical results indicate that adverse selection measures are not effective enough to detect the price impact of trading activity carried out by these informed investors.
Long-term, or informed, investors hold long-lived private information that they use to choose whether to increase their stock ownership. In a pre-filing environment, this information asymmetry has an effect on the stock’s liquidity, but this asymmetry ceases to exist after the 13D report is filed with the SEC (the event date). Informed investors earn excess cumulative returns of 6% around the event date (t – 10, t + 1). Thus, 13D filers’ trade information is valuable, but traditional adverse selection measures fail to identify informed trading. Informed investors choose when and how to trade, and hence, they prefer to trade more when trading volume is high, which leads to lower price impact (30% lower than the average).
How Is This Article Useful to Practitioners?
Information asymmetry related to private information held by long-term investors ceases to exist within 10 days of crossing the 5% ownership mark, but knowledge of the active participation by informed investors causes market participants to earn extra returns over and above risk-adjusted market returns. The average market-adjusted returns on days when informed investors trade is 0.64% compared with –0.04% returns on days when they do not trade.
During the pre-event period, informed investors trade a large fraction (25%) of the daily trading volume, and the average increase in the holdings are 0.3% per day. Investors gradually increase the percentage of ownership every day until 10 days prior to the filing day, and then they trade more aggressively on the filing day (~1% outstanding shares).
The authors’ results strongly suggest that liquidity is much higher on the days during which informed investors trade, and this trend is more prominent for NASDAQ stocks than NYSE-listed companies. During the pre-event period, the adverse selection measures are lower and stock liquidity is higher, and therefore, informed investors might place limit orders. Closer to the event date, the trading activity of informed investors increases, and they choose to cross the 5% ownership threshold at times when stock liquidity is higher. But they are more likely to use market orders instead of limit orders after the event date.
How Did the Authors Conduct This Research?
The authors compile data from varied sources, including stock returns, volume, and prices from CRSP. Intraday transactions data are compiled from the Trade and Quote (TAQ) database, whereas transaction details of informed investors are retrieved from 13D filings using the SEC EDGAR database. The authors discard certificates, American depositary receipts, units, foreign companies, closed-end funds, preferred stocks, American Trust components, and REITs for a final sample of 3,126 13D reports filed during the period of 1994–2010.
The authors analyze the trading strategy of informed investors by calculating the probability that informed investors trade at least one share on a given day and the percentage of outstanding shares traded by them. Analysis of average buy-and-hold returns greater than market returns for a period of 60 days prior to the filing date to 40 days after the filing date indicates significant positive abnormal returns around the filing date.
To analyze the impact of informed trading on stock liquidity, the authors use such liquidity measures as Kyle’s lambda, the effective spread, price impact, daily bid–ask spread, Amihud illiquidity, probability of informed trade (PIN), and so on. They test how liquidity measures behave on days when informed investors trade compared with days when they do not trade. Use of a difference-in-differences approach indicates that stock liquidity is higher not only when informed investors trade but also relative to stocks with similar characteristics, such as market cap, industry, and exchange.
The authors offer good insights on trading strategies adopted by informed investors and the effects of these trading activities on such broad market characteristics as returns and liquidity.