Does aggregate insider trading predict stock returns in China?

• Date: 01 April 2019
• Author: Qing He,Jing Wen,Bingqian Cheng
• DOI: http://doi.org/10.1002/ijfe.1699
• Published date: 01 April 2019

RESEARCH ARTICLE

Does aggregate insider trading predict stock returns in

China?

Qing He

1

| Bingqian Cheng

2

| Jing Wen

3

1

China Financial Policy Research Center

and School of Finance, Renmin University

of China, Beijing, China

2

School of Economics and Management,

Tsinghua University, Beijing, China

3

Columbia Business School, Columbia

University, New York City, New York,

USA

Correspondence

Qing He, School of Finance, Renmin

University of China, Beijing, China.

Email: qinghe@ruc.edu.cn

Funding information

MOE Project of Key Research Institute of

Humanities and Social Sciences at Uni-

versities, Grant/Award Number:

16JJD790056; Fundamental Research

Funds for the Central Universities;

Research Funds of Renmin University of

China, Grant/Award Number: 13XNJ003

Abstract

This paper studies the information content of aggregate insiders' transactions

in their own firms in China by analysing approximately 28,000 open market

transactions from July 2007 to December 2014. The evidence suggests that pub-

licly available information about aggregate insiders' transactions cannot predict

future stock returns. However, the ability of aggregate insiders' transactions to

predict future stock returns is positively associated with the strength of corpo-

rate governance. Results from vector autoregressive models and examination of

profitable strategies corroborate these findings.

KEYWORDS

corporate governance, China, insider transactions, market return, ownership concentration, state‐

owned enterprise

1|INTRODUCTION

With the rise of the Chinese economy, China's capital

market increasingly attracts overseas participants. How-

ever, there has been strong evidence that the extraction

of private benefits by corporate insiders is ubiquitous in

the Chinese capital market. Insiders are able to undertake

a variety of undisclosed transactions or manipulate infor-

mation disclosures to benefit themselves at the expense of

outside investors (He & Rui, 2016; Jiang & Zaman, 2010;

Morck, Yeung, & Yu, 2000).

In order to strengthen investor protections, the China

Securities Regulatory Commission (CSRC) and other reg-

ulatory authorities have made considerable progress on

regulating insiders' transactions. Provisions regarding

insiders' transactions were stipulated in the Securities

Law of the People's Republic of China (Securities Law),

which was proposed on December 29, 1998, and amended

further several times.

1

Nonetheless, inadequate legal

institutions weaken the efficacy of regulation. In view of

the difficulty of monitoring corporate insiders' transac-

tions, on August 15, 2007, the CSRC declared the Rules

on the Management of Shares Held by the Directors,

Supervisors, and Senior Management Officers of Listed

Companies (RMSHLC, No.56 [2007] CSRC) and required

compliance from all listed companies. According to this

regulation, corporate insiders are required to report their

firm share transactions to their companies no later than

the second business day after a transaction. The transac-

tion information is disclosed immediately on the stock

exchange's web platform.

China's mandatory disclosure of insiders' transactions

aims to improve the information environment and hence

enhance investor protection in an emerging market econ-

omy. Numerous evidence shows that insider transactions

are informative (Jaffe, 1974; Rozeff & Zaman, 1988;

Received: 11 May 2017 Revised: 21 July 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1699

922 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:922–942.wileyonlinelibrary.com/journal/ijfe

Seyhun, 1986, 2000). Corporate insiders, by virtue of their

job function, have access to privileged information about

future cash flows and discount rates that are not reflected

in stock prices. The disclosure of their transactions helps

investors to incorporate various information (i.e., firm‐

specific or economy‐wide factors), into stock prices, and

then accelerate price discovery (Hirschey, Slovin, &

Zaima, 1990; Huddart, Hughes, & Levine, 2001). Seyhun

(1988, 1992) shows that the aggregation of insider trans-

actions can predict market returns for the subsequent

2 months. Fidrmuc, Goergen, and Rennoboog (2006)

show that firms experience a significant abnormal return

after an insider's trade of a firm share. Lakonishok and

Lee (2001) find that the aggregate insider trading has

both time‐series and cross‐sectional predicting power,

and the message is more informative for smaller firms.

However, using vector autoregressive (VAR) model,

Chowdhury, Howe, and Lin (1993) find that shocks in

market returns have greater impact on insider activities,

rather than the opposite direction, and in fact, neither is

the amount of the mispricing nor the relationship

between the mispricing and aggregate insider transac-

tions is strong enough for profitable strategy. More

recently, Jiang and Zaman (2010) distinguish between

contrarian strategy and managerial timing by dissecting

realized market returns and concludes that aggregate

insider trading has rather strong predictive power

because of the ability to forecast unexpected future cash

flow. Brochet, Jagolinzer, and Riedl (2013) investigates

the profits of insider trading after SOX

2

and find that

the mean abnormal returns for purchases and sales are

1.89% and −0.11%, respectively, over a 3‐day window

following insider transactions.

If the China's mandatory disclosure system works, we

should have the following expectations. First, it provides

a platform for the market and regulatory agencies to

monitor the behaviour of corporate insiders. By disclosing

their transactions, the ensuing market reactions and reg-

ulatory interventions are expected to discipline insiders'

behaviour. Hence, insiders are less likely to use private

firm‐specific information to trade firm shares in the secu-

rity market. Illegal insider trading or the expropriation of

minority shareholders should be mitigated. Second, to the

extent that noise trading is a market‐wide phenomenon

in China,

3

information‐related trading by corporate

insiders can uncover mispricing in their own firms, con-

tributing the discovery of fundamental values.

To examine this, we investigate the information con-

tent of aggregated trading by corporate insiders in their

firms and address the prediction power of aggregated

insider trading over future market returns. The rationale

is that if the regulation functions well, then the

mispricing observed by corporate insiders is primarily

caused by publicly available information, such as changes

in economy‐wide activity, rather than pure firm‐specific

information. Subsequently, when the market recognizes

changes in economy‐wide activity, most security prices

will also change. As corporate insiders trade prior to

changes in security returns, their transactions contain a

forecast component of the market return. A positive rela-

tionship between aggregate insiders' transactions and

subsequent market return should be expected (Seyhun,

1988).

Using approximately 28,000 open market sales and

purchases by insiders from July 2007 to December 2014

in China, we investigate the degree to which market

returns are predicted by aggregate insider transactions.

We find that multiweek aggregate insider trading data

could only provide modest evidence on the predictability

on future stock returns. We do not find any significant

relation between aggregate insider trading activity in a

given week and the market returns for the subsequent

8 weeks. However, the evidence shows that aggregate

insider trading can predict the future stock returns of pri-

vate companies. In firms with a less concentrated owner-

ship structure and less deviation between control and

cash flow rights, future market returns remain predict-

able after the disclosure of insider trading information.

Results from VAR models and examination of profitable

strategies corroborate these findings.

Combining the findings from our analysis, we con-

clude that corporate insiders generally do not trade on

the basis of economy‐wide information. The mandatory

disclosure scheme only plays a rather limited role in reg-

ulating insiders' behaviour. Corporate insiders still have

ample opportunities to make self‐serving transactions or

obtain other private benefits through privileged informa-

tion. On the other hand, the strength of the prediction

power of aggregate insider trading for future market

returns is negatively related with expropriation risk. More

specifically, in firms characterized by less expropriation

risk, insiders are more likely to be observed and to trade

based on economy‐wide information. While, in firms

with greater expropriation risk, insiders are more likely

to selectively report their transactions and make self‐serv-

ing transactions. Hence, they are less likely to trade on

the basis of mispricing caused by economy‐wide informa-

tion. In this sense, the mandatory disclosure of insiders'

transactions does not effectively correct corporate

insiders' misconduct. Many constraints, such as weak

law enforcement and weak corporate governance, limit

the impact of the mandatory disclosure of insider trading

on regulating corporate insiders' behaviour.

Although this study investigates the prediction power

of China's insider transactions for future market returns,

China has most of the typical features of emerging

HE ET AL.923