Institutional owners have traditionally been thought of as passive investors that have little concern for or influence on corporate policies and decisions. In contrast, recent literature shows that while many institutions are passive in terms of their investment choices and holdings, they are not passive in their role as monitors. For example, Appel et al. (2016) find that index mutual funds influence firms’ governance choices. Others find institutional owners exert influence over firms’ dividend choices (Crane et al. (2016)) and corporate tax strategies (Bird and Karolyi (2017), Khan et al. (2017)). In a new study, we examine how institutional ownership affects insider trading in a setting that allows us to more precisely identify causal effects.
Despite legal prohibitions, prior literature consistently finds insiders’ trades are often based on private information, as evidenced by the abnormal profits their trades earn on average. When insiders trade on the basis of their private information, their activities have important implications for shareholders. Institutional owners will weigh the expected costs and benefits when determining whether and to what degree they should monitor or restrict insider trading. On the cost side, informed insider trading is associated with higher litigation risk (Jagolinzer and Roulstone (2009); Johnson et al. (2000)) and higher information asymmetry (Billings and Cedergren (2015)). On the benefits side, allowing insider trading can provide stronger incentives for managers to increase firm value (Carlton and Fischel (1983); Leland (1992)) and allows firms to reduce CEO compensation (Henderson (2011); Roulstone (2003)).
In order to more reliably identify the causal effects, we exploit plausibly exogenous differences in institutional ownership caused by annual reconstitutions of the Russell 1000 (R1000) and Russell 2000 (R2000) stock indexes. We employ a regression discontinuity (RD) design as our primary research methodology. We first investigate whether differences in institutional ownership lead to differences in insider trading frequency. Consistent with our hypothesis, higher institutional ownership results in significantly fewer buy and sell trades. The effects are both statistically and economically significant. We next examine differences in average trade profitability. Consistent with our expectations, the average profitability of sell transactions is significantly lower when institutional ownership is higher. The lower abnormal returns indicate that fewer sales are based on private information when institutional monitoring is higher. In contrast, we find limited evidence that the profitability of purchases is negatively affected by institutional ownership levels. This asymmetry in results is likely due in part to institutional owners’ concerns about litigation risk, which is higher for insiders sell (Piotroski and Roulstone (2008)), and in part due to few incentives for insiders to buy shares in the absence of private information. In additional tests, we categorize insider trades as routine or opportunistic using the methodology in Cohen et al. (2012). We find significant reductions only in trading frequency and profitability for opportunistic trades; i.e., those most likely to be based on private information. Overall, our evidence indicates institutional owners consider informed insider trading as undesirable.
One way firms can respond to institutional owners’ pressure to reduce informed insider trading is to adopt new blackout policies or more strictly enforce existing ones. In either case, fewer insider trades will occur during blackout periods when institutional ownership is higher. We use the method developed in Roulstone (2003) to infer when a firms is more likely to have an effective blackout policy. We find the likelihood of a blackout policy is significantly higher when institutional ownership is higher. Thus, our evidence indicates one way institutional investors affect insider trading is through firms adopting and enforcing specific policies to restrict insider trading.
Institutional ownership is likely endogenous with other factors, such as firm size, board structure, and the information environment, that directly affect insider trading. As prior studies have not taken this into account, their results are likely biased and difficult to interpret reliably. Perhaps as a result, prior studies have produced mixed results. Huddart and Ke (2007) find a negative association between institutional ownership and abnormal returns following insider trades. Bricker and Markarian (2015) find institutional ownership is positively associated with the profitability of purchases but negatively associated with the profitability of sales. In contrast, Skaife et al. (2013) do not find any significant associations between institutional ownership and insider trading profitability. As such, our approach contributes to the literature by allowing for relatively clearer causal inferences and clarifying our understanding of how institutional ownership influences insider trading. We also extend the literature by analyzing how institutional ownership affects the likelihood firms have effective blackout policies. These analyses illustrate one channel through which institutions’ preferences influence internal firm policies.
Overall, our results provide new insights into the role of institutional investors as external monitors and suggest institutions generally view privately informed insider trading as a manifestation of agency problems and seek to curb it.
This post comes to us from Professor Stephen A. Hillegeist at Arizona State University and Liwei Weng, who is a PhD student there. It is based on their recent article, “Institutional Ownership and Insider Trading: Quasi-Experimental Evidence,” available here.