Last Saturday, The Wall Street Journal broke the story of a massive multi-year federal investigation into rampant insider trading activities. On Monday, the offices of three investment firms were raided by FBI agents in connection with the investigation. Details of the charges and findings have yet to be fully disclosed. Nevertheless, this is certainly the beginning of national, and perhaps global, discussion about insider trading.
Insider trading can be loosely defined as trading on material non-public information – that is information that can move the price of a security and has not been disseminated or made available to investing public. Unfortunately, there is a lot of gray area when it comes to words like material, non-public, and even information. For investment professionals, this gray area quickly becomes black ice on a slippery slope of ethical and legal rationalizations.
Even the CFA Institute, the organization that grants the respected Chartered Financial Analyst designation and has a reputation for being conservative in its positions, seems to provide some wiggle room. In its Code of Ethics and Standards of Professional Conduct, there is a subsection titled Mosaic Theory, which states that an analyst “may use significant conclusions derived from the analysis of public and nonmaterial nonpublic information as a basis for investment recommendations and decisions even if those conclusions would have been material inside information had they been communicated directly to the analyst by a company.”
If pieces of nonmaterial nonpublic information lead to a material conclusion, does that information really continue to be nonmaterial? Mosaic theory is likely to become a hot topic, especially as we learn more about the networks of investment experts involved in the latest federal investigations.
Analysts could always err on the side of caution and throw out any information that seems to be in the gray area. But investment firms often have incentive structures that almost encourage the exploitation of these gray areas. Consultants, research analysts, portfolio managers, traders, et cetera, are only worth as much as the performance of their recommendations and the return on their investments. Those whose investments have the highest returns are rewarded with more clients and more assets to manage. This translates to more fees and bigger paydays.
Most professionals provide recommendations and investments with returns that are average at best. But in their business, average is considered mediocre. It can be reason enough for an investor to seek alternatives. Not only could less-than-outstanding performance lead to a loss of clients and assets as they flock to the outperformers, this could eventually lead to the loss of jobs and the shuttering of a fund. Greed is not always the only motivator; sometimes, the motivations are fear and desperation.
Of course, no one is really going to buy the fear and desperation excuse. The financial services industry has been struggling to earn back the public’s trust for years. This investigation, regardless of its findings, is just another setback.
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