Informed Trading through the Accounts of Children

In our paper, Informed Trading through the Accounts of Children, forthcoming in the Journal of Finance, we introduce a novel measure of the probability of information-based trading in a stock, namely, BABYPIN, the proportion of total trading through the accounts of underaged investors. We begin by empirically validating this measure by showing that underaged accountholders are extremely successful at picking stocks, especially when they trade just before large price changes, major earnings announcements, and takeover announcements. We next show that BABYPIN is priced in the cross section of stock returns, consistent with Easley and O’Hara (2004).

There are two reasons to expect a high proportion of informed trading through underaged investor accounts. First, guardians who open accounts and trade on behalf of young children are likely to be above-average investors. We expect these individuals to have more wealth (to bestow on offspring) and to be more successful at investing, possibly due to superior cognitive skills or comparative advantages in obtaining value-relevant information. These attributes, combined with a basic parental instinct to share the benefits of any information advantage with one’s offspring, could lead to a disproportionate number of underaged accounts that bear the fruits of informed trading.

Second, underaged accounts can be used to camouflage illegal insider trading by guardians. Although such behavior may seem unlikely, Internet Appendix Section I documents several recent insider trading cases involving the accounts of children. Note that while we use the term camouflage in the sense of hiding from authorities, an informed guardian could also use the accounts of children to reduce the price impact of trades, in the sense of Kyle (1985).

We employ data from Euroclear Finland Ltd (Euroclear) during the period 1995 to 2010. Euroclear records all changes in daily shareholdings for every investor trading on the Nasdaq OMX Helsinki exchange, as well as the age of the investor. We separately analyze the performance of trades made in underaged accounts (defined as accountholders aged 0-10 years) versus trades by accountholders in older age categories.

We find that underaged accountholders exhibit superior stock-picking skills on both the buy side and the sell side over the days immediately following trades. They significantly outperform older investors by an average of 9 basis points (bp) based on all trades made one day earlier, by 7 bp based on trades two days earlier, by another 5 bp for trades three days earlier, and by an average of 2 bp per day for previous trades made over days -4 through –10.

Since this outperformance is especially evident for short horizons, it likely stems from superior private information that is about to become public. We explore this possibility, and find that underaged accountholders perform extremely well when they trade just before major information events. For example, on the day before major earnings announcements, young accountholders trade in the correct direction 57% of the time and outperform older investors by an average cumulative abnormal return on days 0 and +1 (CAR(0,+1)) of 1.1%. Likewise, one day ahead of large price changes, young accounts trade in the correct direction 58% of the time and outperform older investors by an average CAR(0,+1) of 2.1%. Finally, on the day before takeover announcements, their proportion of correct trades is 72% and their mean outperformance is a CAR(0,+1) of more than 12%.

We extend the analysis by examining the performance of two sets of guardians, who are matched to underaged accounts using either family surname or similar trades in corporate accounts. Consistent with our expectations, these guardians have significantly more wealth than other adults. In addition, when guardians trade through their own accounts or through corporate accounts, they outperform other adults on the buy side but not on the sell side. This asymmetry suggests that a relatively high proportion of guardian sales are liquidity- motivated. In contrast, the fact that underaged accounts outperform on both the buy side and the sell side indicates that liquidity-motivated selling is less prevalent for underaged accounts. Similarly, while guardians outperform when they trade in their own accounts just before major earnings announcements or large price changes, they do so by a wider margin when they trade through underaged accounts. Furthermore, guardians do not outperform when they trade in their own accounts before takeover announcements, but they do so when they trade through underaged accounts. Together, this evidence suggests that informed guardians conduct a higher proportion of informed trading through underaged accounts, relative to their own accounts.

The emerging picture points to a broader group of informed guardians who tend to channel their best ideas through the accounts of children. As a result, the most valuable private information from guardians is filtered through underaged accounts to yield a greater degree of outperformance. Based on this evidence, we propose that BABYPIN offers a low-noise proxy for the probability of trading with a privately informed investor.

Consistent with this view, we show that BABYPIN is related to future stock returns, confirming the prediction in Easley and O’Hara (2004). We find that the tercile of stocks with the highest value of BABYPIN in the previous month significantly outperforms the tercile with the lowest BABYPIN by more than 1% per month, on average. These results are robust to the inclusion of standard risk factors, and they also hold in cross-sectional regression analysis controlling for firm characteristics such as size, spread, and the traditional PIN measure.

Our study contributes to the literature in two areas. First, we build upon the growing number of studies that document that some groups of individual investors are more informed or skilled than others. For example, Grinblatt, Keloharju, and Linnainma (2011, 2012) find that investors with greater IQ have superior stock-picking skills. Seru, Shumway, and Stoffman (2010) show that the disposition effect subsides and performance improves as individual investors become more experienced. Cohen, Frazzini, and Malloy (2008, 2010) and Cohen, Malloy, and Pomorski (2012) show that corporate insiders and investors with access to social networks through educational affiliation enjoy an advantage in obtaining value-relevant information. Finally, Ivkovic and Weisbenner (2005) find that individuals who invest in local companies outperform other individual investors—a finding confirmed in this study.

Our study also contributes to the recent literature that examines whether information asymmetry affects required returns. Unique among proxies for information asymmetry, we directly establish the empirical validity of BABYPIN, and show that a large proportion of trading through underaged accounts is motivated by superior private information. Our evidence that BABYPIN is strongly related to excess returns in the relatively illiquid Finnish market is consistent with the models in Easley and O’Hara (2004) and Lambert, Leuz, and Verrecchia (2011).

The full paper is available for download here.