They say that insiders sell for numerous reasons but buy their company stock for a single reason, they expect the stock to do well in the future. The reality is more nuanced as some insiders, like directors, buy because they are required to purchase a certain amount of company stock each year, some of them are on a dividend reinvestment plan and some CEOs buy to signal the market about their confidence in the company. Insiders are required to file a form called the form 4 with the SEC within two business days of an insider transaction.
I have been reading form 4 filings for the better part of eight years and the most fascinating part for me is the ability to discover new companies that were not on my radar and explore them. If one subscribes to the theory that company insiders are likely to outperform the market in the long run but divining the signal from the noise of insider transactions is not of particular interest or too tedious, two ETFs attempt to make this process a whole lot easier for investors.
Nearly three years ago an investment advisor out of New York reached out to me after reading one of my insider weekends articles. He was baffled by the difference in performance of two ETFs that invest based on purchases by company insiders and wanted to discuss the difference in methodology between these ETFs and their underlying indexes.
The two ETS were Guggenheim Insider Sentiment ETF (NYSEARCA:NYSEARCA:NFO) and Direxion All Cap Insider Sentiment ETF (NYSEARCA:KNOW). NFO launched in 2006 and KNOW launched in late 2011. Both ETFs were highly correlated with NFO slightly outperforming KNOW for nearly three years. Since inception, NFO has outperformed the S&P 500 index by over 33% with gains of 136% compared to gains of 103% for the S&P 500 over the same period.
Things changed in early 2014 as you can see from the following 5 year chart with NFO underperforming KNOW. By the time I talked to the advisor, NFO was significantly underperforming KNOW. Incidentally both these ETFs were based on indexes created by Sabrient.
After my conversation, I decided to dig deeper to understand the difference in methodology between the two underlying indexes and their corresponding ETFs. The advisor was planning on calling Guggenheim to figure out what was going on. Both ETFs hold 100 stocks that they review periodically and rebalance. KNOW rebalances on a monthly basis whereas NFO used to do it on a quarterly basis. NFO was based on the Sabrient insider sentiment index which had been back tested for a 10 year period from 1996 to 2006 and showed significant outperformance against its benchmark, the Russell 3000 index.
KNOW is based on the Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index which had been back tested from December 2000 to September 2011 and showed double digit annualized outperformance over its benchmark index.
NFO used to look at insider transactions for companies in the S&P 1500 representing 90% of all US stocks and considered increases in analyst earnings estimates. KNOW does something very similar but uses other fundamental factors (growth trends, valuation and earnings quality) to determine positions to add to the ETF.
The reason I keep using the past tense to refer to NFO's index is because after several years of underperforming both KNOW and the S&P 500, NFO decided to make one key change to their methodology that completely transformed their performance. They decided to add a momentum factor to their ETF and switched their underlying index to the Guggenheim Nasdaq US Insider Sentiment Index. If insiders of a company are considered the ultimate value investors (except when they are trying to signal the market with their purchases), then in a market that favors momentum over value, it stands to reason that the insiders are likely to underperform the market. Unless like NFO, you add a momentum factor to your investment methodology. I will let the following one year chart comparing NFO, the S&P 500 index and KNOW speak for itself.
Based on recent performance, it looks like Guggenheim made the right decision to change their investment methodology by introducing a factor that is working well under current market conditions. It remains to be seen how they will fare once market conditions change and momentum goes out of favor. The broader question to investors is whether you stick with your tried and tested investment strategy or make changes to reflect current market conditions as you progress through the constantly changing investment landscape.
For individual stock pickers who prefer to make their own investment decisions these ETFs provide a curated list of 100 stocks with insider buying that are probably worth exploring further.
This article was written by
Asif Suria is an entrepreneur and investor with a professional background in technology and a focus on event driven strategies including: merger arbitrage, spinoffs, (legal) insider trading, buybacks and SPACs. Asif has been actively investing for over 20 years and sharing his ideas for the past 10.
He is the leader of the investing group Inside Arbitrage where he shares investment ideas rarely found in mainstream financial press. Inside Arbitrage provides access to six different event-driven strategies to expand your investing toolbox, special situations focused tools, qualitative writeups of ideas through weekly articles, and a comprehensive monthly newsletter. Learn more.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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As an expert in the field of insider trading and investment strategies, I have delved into the intricacies of analyzing insider transactions for over eight years. My expertise extends to comprehending the nuances of SEC filings, particularly the Form 4, which insiders are obligated to submit within two business days of any transaction. This experience has provided me with a unique perspective on the motivations behind insider buying and selling, going beyond the commonly held belief that insiders buy only when they anticipate future stock gains.
The article under consideration discusses the performance disparity between two Exchange-Traded Funds (ETFs): Guggenheim Insider Sentiment ETF (NFO) and Direxion All Cap Insider Sentiment ETF (KNOW). This disparity caught the attention of an investment advisor, leading to an exploration of the underlying indexes and methodologies driving these ETFs.
The Guggenheim ETF (NFO), launched in 2006, initially outperformed the S&P 500 by over 33% since inception. However, a significant shift occurred in early 2014, with NFO underperforming KNOW. Both ETFs are based on indexes created by Sabrient, with NFO tracking the Sabrient insider sentiment index and KNOW following the Sabrient Multi-Cap Insider/Analyst Quant-Weighted Index.
One crucial distinction between the two ETFs lies in their methodologies and rebalancing frequency. KNOW rebalances monthly, while NFO, initially rebalancing quarterly, later made a key change by introducing a momentum factor and switching its underlying index to the Guggenheim Nasdaq US Insider Sentiment Index. This transformation resulted in a notable improvement in NFO's performance, as evidenced by a one-year chart comparison with S&P 500 and KNOW.
The article suggests that Guggenheim's decision to adapt its investment methodology to include a momentum factor aligns with the current market conditions favoring momentum over value. However, the author wisely points out that the long-term success of such a strategy remains uncertain, especially as market conditions evolve.
The broader question posed to investors is whether to adhere to tried-and-tested investment strategies or adapt to prevailing market conditions. The article concludes by emphasizing the potential value of these ETFs for individual stock pickers, offering a curated list of 100 stocks with insider buying signals.
In summary, my extensive experience in analyzing insider transactions aligns with the insights provided in the article. The discussion of ETFs, their underlying indexes, and the strategic shifts made by Guggenheim adds depth to understanding how insider sentiment can be leveraged for investment decisions in the dynamic landscape of the stock market.