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The Easiest Way To Profit From Insider Buying

While insider action can provide valuable hints about where a stock is headed, many investors consider this activity most helpful with buying decisions.

After all, as legendary fund manager Peter Lynch once noted, insiders might sell their firm's stock for any number of reasons. But they only buy it for one reason: they think it's going to go up. And who better to make such a call than the people most closely associated with a company?

Trouble is, keeping abreast of insider buying trends in such a large universe of stocks is much too time-consuming for most individual investors. But no matter. There's a simpler way to own stocks with heavy insider buying, and recent performance suggests it's capable of generating market-beating returns.

The method: investing in exchange-traded funds designed specifically to offer broad exposure to stocks with robust insider buying. Currently, there are two choices, the Guggenheim Insider Sentiment ETF (NYSE: NFO ) and the Direxion All Cap Insider Sentiment ETF (NYSE: KNOW ) .

Both are index funds (with reasonable expense ratios of less than 70 basis points). NFO tracks the Sabrient Insider Sentiment Index, an equal-weight benchmark of the 100 stocks with the highest composite rankings incorporating four factors: the amount of insider buying; the percentage increase in each purchaser's holdings; the frequency of positive revisions in analysts' earnings forecasts; and the percentage increase in revised earnings forecasts.

The index is rebalanced quarterly, with the goal of keeping each holding as closely as possible to 1% of the overall portfolio.

KNOW mirrors the Sabrient All-Cap Insider/Analyst Quant-Weighted Index, which is also a 100-stock benchmark based on the four criteria used to build the Insider Sentiment Index. But in this case, Sabrient also employs a "defensive sentiment overlay" that favors holdings with histories of especially strong performance in weak markets, high free cash flow yields and strong dividend yields.

The 50 highest-ranked stocks receive the largest index weightings, ranging from about 1%-to-3% depending on rank, while the bottom 50 get a flat 0.35% weighting. Rebalancing occurs monthly.

NFO and KNOW consist almost entirely of U.S. equities. But as the following tables show, fund allocations are substantially different, with KNOW showing a noticeable tilt toward mid- and large-cap stocks.

In terms of sector allocation, NFO is weighted more toward basic materials, real estate and energy, while KNOW allocates more to healthcare and, to some extent, technology. The funds' top 5 holdings lists bear no resemblance, though pharmaceutical distribution giant AmerisourceBergen Corp. (NYSE: ABC ) is a top-10 holding in both portfolios.

Currently, the performance advantage belongs to KNOW, which generated nearly a 19% rate of return during the past three years, versus about 14% for NFO and 16% for the S&P 500. Broadly speaking, KNOW has seen an especially nice boost from larger allocations to healthcare and technology, two of the best-performing sectors of the economy for some time now.

Of the fund's top 10 holdings, KAR Auction Services, Inc. (NYSE: KAR ), The Hanover Insurance Group, Inc. (NYSE: THG ) and AmerisourceBergen have been the best growth stories recently, with three-year rates of return ranging from 23%-to-43%. As a group, insiders increased their positions in all three stocks by double-digits during the past year, according to Morningstar.

NFO has been hindered by greater exposure to basic materials and energy, the two worst-performing sectors going back at least five years. However, larger allocations to those areas could later become a big advantage, since cyclical busts like these two sectors have suffered often transform into major booms once the tables finally turn. In the meantime, NFO holds sizeable stakes in sectors that fared very well the past few years such as consumer cyclicals, technology and industrials.

Among the fund's biggest winners: undergarments maker Hanesbrands Inc. (NYSE: HBI ), biotechnology firm Ligand Pharmaceuticals Inc. (Nasdaq: LGND ) and petroleum refiner Tesoro Corp. (NYSE: TSO ), with three-year rates of return ranging from 52%-to-69%. Insider buying has been strong in each case, especially at HBI and TSO, where insiders more than doubled their positions during the past year.

Perhaps in anticipation of a cyclical rebound, insiders have also been scooping up energy and materials stocks now worth only a fraction of what they traded for three years ago, like minerals/metals supplier Cliffs Natural Resources Inc. (NYSE: CLF ), oil and gas E&P firm EV Energy Partners (Nasdaq: EVEP ) and gold miner Newmont Mining Corp. (NYSE: NEM ). At these firms, insiders bolstered their holdings by 14%, 33% and 117%, respectively, in the past year.

Risks To Consider: While insiders may know a company best, they're not infallible. Indeed, following insiders into energy and materials stocks has generally been a recipe for disaster for several years now. Heavy insider buying is no guarantee of an imminent rebound. Also, NFO and KNOW were only launched about nine years and three years ago, respectively, so they're not yet time-tested through numerous market cycles.

Action To Take --> In my view, both the Guggenheim Insider Sentiment ETF and the Direxion All Cap Insider Sentiment ETF have been around long enough to prove their mettle. So I'm comfortable suggesting both to investors seeking a simple approach to capitalizing on insider buying. These investors can either split their allocation to this strategy between the two funds or go entirely with one if it offers an asset mix they find more appealing.

[Editor's Note] Insiders can reveal hidden opportunities for massive returns... but follow too closely -- into energy and materials stocks, for example -- and you'll run into disaster. That's why funds like KNOW play defense by filling up on income generating high-yielders.

Of course, no strategy can protect investors from all market turmoil, but my colleague Nathan Slaughter's comes close. His in-depth research into dividend-paying companies has turned out a strategy that's outperformed the S&P during both the "dot-com" bubble and the 2008 financial collapse... all while returning an average of 15% per year since 1982. To learn more about his " Total Yield " investing strategy, click here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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