Insider Trading: How Hedge Funds Look for an Edge

Insider Trading: How Hedge Funds Look for an Edge

Twentieth Century Fox

Michael Douglas memorably brought insider trading to the public consciousness as Gordon Gekko. Now, 25 years later, the man whose fictional alter ego declared that “greed, for lack of a better word is good” is taking to the airwaves to urge anyone who knows about insider trading in the real world to report it to the FBI.

Even if Wall Street’s denizens are convinced by the message to turn in their colleagues or accomplices, however, it’s hard to imagine how the FBI is going to find the resources to investigate all the reports it gets. In the last three years, prosecutors have convicted 57 individuals of insider-trading offenses (or persuaded them to plead guilty), and have no fewer than 120 more in their sights as “targets” against whom they are actively building cases. The investigators are pulling in a broader array of suspects in every investigation – it isn’t just a matter of a bank executive’s mistress telling her brother about a pending deal, or an analyst leaking word about pending ratings upgrades to a college fraternity brother. It’s far more systematic.

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At the center of the FBI effort, perhaps inevitably, are hedge fund managers like Raj Rajaratnam, who last May drew the toughest sentence yet for insider trading – 11 years imprisonment. But for some of those who tracked the case involving the Galleon Group founder, the only question was why so many people seemed surprised that the fund’s profits were the result of insider trading?

Carter Furr, a managing director in charge of alternative investment strategies at Signature, a Virginia-based wealth management firm, told me last spring, shortly after Rajaratnam’s conviction, that when he met with “Raj” at an introductory meeting set up by Goldman Sachs (which routinely offers that kind of service for hedge fund clients) he immediately began wondering how anyone, in today’s financial markets, could get it right so often. That’s especially true given that Galleon was making profits on ultra-liquid and ultra-efficient large-cap stocks – the kind of investments where getting a reliable “information edge” is notoriously difficult to do in a legal and consistent manner. “It was clear that this was a non-starter for us,” Furr recalled.

Indeed, prosecutors proved that the Galleon Group generated its returns by bribing or coercing its employees others into providing Rajaratnam with insider information on companies such as AMD (AMD) and Polycom (PLCM), including advance warning of outsize earnings.

The pressure is on hedge funds to generate alpha – or excess returns above and beyond what the market itself is doing. And if you’re running a large hedge fund (the Galleon Group had $7 billion in assets at its peak), the odds are that a portion of those assets will be put to work in large-cap stocks and other ultra-liquid markets where, between tougher disclosure rules and the sheer volume of information that is out there, it is very hard indeed to get even a fleeting “information edge.” Certainly, a hedge fund manager can move into areas other than the commonplace “long/short” strategy, but those styles can move in or out of favor, and may involve taking more risks, including putting up with lower liquidity levels.

The cold hard facts are:

(a) There are too many hedge funds around, all scrambling for some kind of edge;
(b) When managers whose funds have grown too large and who don’t have the right skills to generate alpha organically begin to flag, the temptation is to push the envelope in terms of what is legal;
(c) The nature of the hedge fund market – including the opacity of the strategies that managers pursue – doesn’t lend itself to simple due diligence on the part of its investors;
(d) As long as alpha is being generated somehow, the tendency on the part of those investors (and others who benefit, such as the trading desks for which a Galleon Group might generate hefty trading commissions) is to “hear no evil, see no evil, speak no evil.”

Due diligence can help, to the extent that the investor has access to information and is skilled enough to evaluate what she is seeing or hearing. In some cases, even very simple questions can be enough to help an interested party determine whether there’s an above-average chance that a hedge fund’s returns were generated with the help of some illicit insider tips. Can a manager identify one of his or her best ideas of the last year – and walk the potential investor through the thought process, from soup to nuts? How much of a manager’s returns come from short-term trades based on upcoming news related to earnings, dividend increases, or deals?

The larger the fund, the more it relies on trying to get an “information edge” or insight when trading large-cap stocks, the greater the possibility that there is something happening in which the FBI may take some interest. Even if the fund’s founder or chief manager isn’t involved directly, those working for him may be tempted to push the envelope out of fear of losing their jobs or simply being humiliated in front of their peers when the top guy hollers at them for failing to come with a great, profitable new idea.

It’s not surprising that the FBI has found another 120 targets (and 120 more individuals who thus far are merely “suspects”) by turning over some more rocks on Wall Street and Main Street. Maybe fear of the Feds will accomplish what ethics, morals and sheer common sense haven’t managed to do: force wannabe Gordon Gekkos to think twice before crossing the line.