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E-MailVyacheslav Fos is Assistant Professor of Finance at Boston College. This post is based on an article by Professor Fos and Pierre Collin-Dufresne, Professor of Finance at the Swiss Finance Institute. Related research from the Program on Corporate Governance includes Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang; and The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here).
In our paper, Do Prices Reveal the Presence of Informed Trading?, forthcoming in the Journal of Finance, we study how empirical measures of stock illiquidity and of adverse selection respond to informed trading by activist shareholders.
An extensive body of theory suggests that stock illiquidity, as measured by the bid-ask spread and by the price impact of trades, should be increasing in the information asymmetry between market participants. An extensive empirical literature employing these illiquidity measures thus assumes that they capture information asymmetry. But, do these empirical measures of adverse selection actually increase with information asymmetry? To test this question one would ideally separate informed from uninformed trades ex-ante and measure their relative impact on price changes. However, since we generally do not know the traders’ information sets, this is hard to do in practice.
In this paper we use a novel data set of trades by investors that we can identify as having substantial private information to study how illiquidity measures actually respond to informed trading. More specifically, we exploit the disclosure requirement Rule 13d-1(a) of the 1934 Securities Exchange Act to identify trades driven by valuable private information. Rule 13d-1(a) requires investors to file with the SEC within 10 days of acquiring more than 5% of any class of securities of a publicly traded company if they have an interest in influencing the management of the company. In addition to having to report their actual position at the time of filing, Item 5(c) of Schedule 13D requires the filer to report the date, price, and quantity of all trades in the target company executed during the 60 days that precede the filing date.
We collect a comprehensive sample of trades from the Schedule 13D filings. We view this sample as an interesting laboratory to study the liquidity and price impact of informed trades. An average Schedule 13D filing in our sample is characterized by a positive and significant market reaction upon announcement. For example, the cumulative return in excess of the market is about 6% in the (t-10, t+1) window around the filing. We document that profits earned by 13D filers are on average highly significant both economically and statistically, even when measured relative to standard risk-return models. To summarize, the evidence shows that Schedule 13D filers have information that is private and valuable. Their pre-announcement trades can thus be classified as informed. We can then document how empirical measures of stock illiquidity respond to these informed trades.
Our main empirical result is that standard measures of adverse selection and of stock illiquidity do not increase with the presence of informed trading. In fact, we find that several measures of adverse selection are lower on days when Schedule 13D filers trade, which suggests that adverse selection is lower and the stock is more liquid when there is significant informed trading in the stock. Importantly, we show that days when Schedule 13D filers trade are characterized by positive and significant market-adjusted returns (that revert slightly on days when they do not trade), which also suggests that informed trades do impact prices. Adverse selection measures, however, decrease despite that positive price impact.
These findings contradict the hypothesis that standard measures of stock price illiquidity, and in particular of adverse selection, capture the severity of the adverse selection problem (at least not when informed traders have long-lived private information similar to that of Schedule 13D filers). We consider two possible mechanisms that could explain this result. First, and consistent with the theoretical model presented in Collin-Dufresne and Fos (2014), activist shareholders might select the timing of their trades, stepping in when the market and/or the target stock happen to be more liquid. In that model, uninformed volume is time varying and persistent (this is captured by allowing noise trading volatility to be stochastic). Informed agents strategically choose to trade more when uninformed volume is high, which leads to a negative relation between informed trading and measured price impact. Indeed, a higher uninformed volume lowers price impact, which leads the informed investor to trade more aggressively but never so much so as to raise the equilibrium price impact. Second, while standard liquidity measures are based on models that assume informed traders mostly demand immediacy, that is, use market orders, Schedule 13D filers possess relatively long-lived information that gives them the flexibility of also placing limit orders. We find empirical evidence that especially before they hit the 5% threshold, 13D filers make extensive use of limit orders (and receive the bid-ask spread rather than pay it). This may further contribute to the apparent improvement in stock liquidity on days when informed investors accumulate shares. We conclude that when informed traders with long-lived information can select when and how to trade, standard measures of stock illiquidity may fail to capture the presence of their trades.
The full paper is available for download here.
