Return Synchronicity and Insider Trading Profitability*

• Published date: 01 December 2020
• DOI: http://doi.org/10.1111/irfi.12246
• Author: Xiaowei Xu,Claire Y.C. Liang,Zhenyang Tang
• Date: 01 December 2020

Return Synchronicity and Insider

Trading Profitability*

CLAIRE Y.C. LIANG

†

,ZHENYANG TANG

‡

AND XIAOWEI XU

§

†

College of Business, Southern Illinois University, Carbondale, IL

‡

Graduate School of Management, Clark University, Worcester, MA and

§

College of Business, University of Rhode Island, Kingston, RI

ABSTRACT

We investigate the association between stock return synchronicity and insider

trading profitability.Morck,YeungandYu(2000)suggestthatgreaterstock

return synchronicity (or R

2

)reflects less firm-specific information in stock prices.

Consistent with the view, we find significantly higher insider profitability in

firms with greater return synchronicity. The results mainly reside in opportunis-

tic trades rather than in routine trades, and are more pronounced f or trades by

key insiders such as officers and directors. Furthermore, our results are weaker

for industry bellwether firms, and stronger for firms with more opaque earnings

or lower institutional ownership. We also document significantly more insider

purchasing activity in firms with greater return synchronicity. Overall, our

results support the view that greater return synchronicity means less firm-

specific information in stock prices, and suggest that insiders take advantage of

this by trading and profiting more from firms with greater return synchronicity.

JEL Code: G14

Accepted: 17 October 2018

A stock’s return variation can come from three sources: market, industry, and

firm. In an attempt to quantify the relative importance of these three compo-

nents, Roll (1988) documents that stock return synchronicity (or R

2

) is surpris-

ingly low in the US, suggesting that most of the stock return variation is firm-

specific and cannot be explained by market-wide or industry factors. Using an

international sample, Morck et al. (2000) show that return synchronicity is

higher in emerging markets and in markets with poorer property rights. The

authors posit that greater return synchronicity reflects less-informative stock

pricing: when prices incorporate less firm-level information relative to other

sources, firm-specific return variation would be lower, resulting in greater return

synchronicity. While many subsequent studies document findings consistent

with Morck et al. (2000), a number of recent studies support the opposite view

that greater return synchronicity may mean more informative stock pricing

* We thank Allaudeen Hameed (the editor), Randall Morck, Rengong Zhang, Mengxin Zhao, an

anonymous associate editor and an anonymous reviewer for helpful comments.

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:4, 2020: pp. 857–895

DOI: 10.1111/irfi.12246

(Teoh et al. 2009; Dasgupta et al. 2010; Hou et al. 2006; Chan and Chan 2014;

Kelly 2014; Li et al. 2014). To reconcile the seemingly contradictory findings,

Morck et al. (2013) emphasize that return synchronicity measures the intensity

of firm-specificinformation, as opposed to a firm’soverall information environ-

ment (which may be influenced by market/industry information). The distinc-

tion between firm-specific versus industry/market information or the overall

information environment is important and it can accommodate the findings

from both camps: more firm-specific information incorporated in stock prices

enhances price informativeness and lowers return synchronicity, but price

informativeness may also come from industry−/market-level information

embedded in prices, which tends to increase return synchronicity. These two

different sources of information both contribute to price informativeness but

have opposing effects on synchronicity. Hence, the documented relation

between synchronicity and an information measure may vary with the type of

information measure chosen in a study.

Following the suggestion of Morck et al. (2013), in this study we shift the focus

back to firm-specificinformation from the debate on price informativeness regard-

ing stock return synchronicity by investigating the relation between synchro nic-

ity and insider trading profitability. Corporate insiders’deep involvement in

corporate decisions grants them superior access to private information of their

firms. Consequently, transactions by corporate insiders contain valuable informa-

tion (Seyhun 1986), and that the information is primarily firm-specific (Demsetz

1986; Piotroski and Roulstone 2004). If greater return synchronicity reflects less

firm-specific information in prices, everything else being equal, it would be easier

for insiders to profit from trading. Hence, we should expect greater insider trading

profitability in firms with greater return synchronicity, especially with purchases

which are more likely to be information-driven than sales (Lakonishok and Lee

2001; Jeng et al. 2003; Gider and Westheide 2016).

Using a sample of insider transactions in the US between 1990 and 2013, we

find that insider profits, measured by cumulative abnormal returns (CARs) fol-

lowing insider purchases, are significantly higher in firms with greater return

synchronicity. When insiders buy shares in the top quintile of firms ranked by

return synchronicity, the 3-day CAR (CAR[0,3]) is 0.3%

1

greater than that in

the bottom quintile. The positive association between insider trading profitabil-

ity and return synchronicity remains statistically and economically significant

over different event windows (ranging from 3 days to 3 months) and in differ-

ent models after controlling for various explanatory variables, and it cannot be

explained by contemporaneous industry or market price movements. In

addition, we examine whether the positive association differs for insiders with

different information sets and across firms with different information environ-

ments. We find that our results mainly reside in opportunistic insider trades,

and largely disappear when routine trades are analyzed. The results are stronger

1 The 0.3% difference is estimated using the Fama–French 3-factor model; when the market

model is used, the difference in 3-day CAR is up to 0.414%.

© 2018 International Review of Finance Ltd. 2018858

International Review of Finance

for trades by key insiders such as top managers and officer-directors, who are

more likely to have access to high-quality, firm-specific information. We also

document weaker results for industry bellwether firms whose fundamentals cor-

relate more with their industries, and stronger results for firms with more opa-

que earnings or less institutional holdings. Finally, we find that insiders exhibit

more purchasing activity in firms with greater return synchronicity. Taken

together, our results support the view that greater return synchronicity means

less firm-specific information embedded in stock prices.

This study contributes to the literature by documenting a positive relation

between return synchronicity and insider trading profit. The implications are two-

fold. First, our study adds to the literature on insider trading by showing that

insiders take advantage of their private information in firms with greater return

synchronicity. We further demonstrate that such an advantage is magnified by a

range of factors, including personal characteristics such as insider roles and trading

patterns, and firm characteristics such as earnings opacity, fundamental correla-

tions with industry peers, and institutional ownership. In addition, we provide

some evidence that insiders trade more when return synchronicity is higher.

Second, this study helps shed light on the ongoing debate over whether

greater stock return synchronicity means more- or less-informative pricing by

abstracting from the informativeness debate and refocusing on firm-specific

information incorporated in prices as suggested by Morck et al. (2013). Since

Morck et al. (2000), a number of studies have examined the relation between

return synchronicity and various information measures, but the conclusions

are mixed. Some studies suggest that when more firm-specific information are

incorporated in stock prices, return synchronicity is lower and prices are more

informative. For example, Durnev et al. (2003) find that stock returns better

predict future earnings when return synchronicity is lower. Durnev et al. (2004)

document higher investment efficiency in firms with lower return synchronic-

ity. Wurgler (2000) and Chen et al. (2007) associate lower return synchronicity

with higher sensitivity of investment to firm value. However, a growing num-

ber of recent studies suggest otherwise, that is, greater return synchronicity

reflects a better information environment. Dasgupta et al. (2010) argue that

when future information is quickly incorporated into stock prices, there should

be less firm-specific“surprise”to investors in the future; as a result, stock return

synchronicity should be higher. Hou et al. (2006) posit that when stock price

fluctuations are caused by investor sentiment, greater return synchronicity

should mean more, rather than less, informative stock pricing. Empirically,

more informative stock pricing implies lower information asymmetry between

insiders and outside investors. Consistent with this view, Chan and Chan

(2014) document smaller seasoned equity offering (SEO) discounts in firms with

greater return synchronicity. Teoh et al. (2009), Kelly (2014), and Li

et al. (2014) also find positive relations between various information efficiency

measures and return synchronicity.

As briefly discussed previously, the seemingly puzzling discrepancy between

these two strands of research may be attributed to the selection of information

© 2018 International Review of Finance Ltd. 2018 859

Return Synchronicity and Insider Trading Profitability