Hedge Funds and Insider Trading: A Bad Deal Just Got Worse

The secret of grand fortunes without apparent cause is a crime forgotten.

– Honoré de Balzac (1835)

Unfortunately, illegal insider trading is rampant and may even be on the rise.

— Preet Bharara, U.S. Attorney (Oct. 22, 2010)

The news over the weekend that federal prosecutors, after a three-year investigation, were on the verge of filing criminal charges against a large number of people for insider trading has shaken Wall Street. On Monday (Nov. 22), the Dow Jones Industrial Average fell more than 140 points midday before recovering most of that loss by the close. The Dow is down another 160 points Tuesday as I write this. One stock that didn’t recover much on Monday is Goldman Sachs (NYSE: GS), which fell $5.62 per share, or 3.4%, on reports that some of its investment bankers tipped off clients about healthcare takeovers.

It’s depressing to hear that the investment game is rigged, but it’s not a surprise. As I wrote in It’s Time to Regulate the Investment Banking Psychopaths, successful investment bankers have a special type of DNA that allows them to violate the law without any pangs of conscience if those laws interrupt their pursuit of a large year-end bonus. Goldman’s alleged involvement is also par for the course as its recent settlement with the SEC for fraud demonstrated.

Hedge Funds and Insider Trading

What may be more surprising are the non-investment bankers implicated in the criminal investigation: “expert network” consultants, lawyers, mutual funds, and hedge funds are also involved.  Apparently, these consultants were providing fund managers with more than simple “insights” into industry dynamics. The involvement of hedge funds is consistent with last year’s salacious insider trading case against the Galleon Group hedge fund, which also ensnared executives at the New Castle Partners hedge fund in a “sex for information” scheme. New Castle employee Danielle Chiesi was quoted as saying that insider trading felt “like an orgasm.” Fourteen people have already pled guilty in the Galleon case. SEC Enforcement Chief Robert Khuzami (who also led the Goldman fraud investigation) has characterized Galleon founder Raj Rajaratnam as a thief, not the prescient investment analyst he claimed to be:

He is not the astute student of company fundamentals or marketplace trends that he is widely thought to be. He is not a master of the universe but rather a master of the Rolodex.

On Monday, the FBI raided three hedge funds, two of which (Level Global Investors and Diamondback Capital Management) are run by former managers of Steven Cohen’s SAC Advisors hedge fund. Steven Cohen is a legendary trader and billionaire. SAC Advisors itself has received a government subpoena and rumors of insider trading have dogged the firm for years.  An amazing 30 percent average annual return for 18 years has a tendency to raise such questions. Call it the Lance Armstrong effect.

In fact, Steven Cohen’s former wife is suing him for $2.75 million, alleging that he fraudulently withheld a portion of his wealth during their divorce proceedings. Supposedly, part of the wealth he hid was ill-gotten gains from insider trading.  Her allegations must be taken with a grain of salt, however, since in a prior complaint she had demanded $100 million and a substantial stake in his hedge fund. It doesn’t make sense to reduce your demands by such a large margin if the original claim was made in good faith. But I digress.

Hedge Funds and Greed

Why do hedge funds feel a need to cheat through insider trading? U.S. Attorney Preet Bharara, who is leading the current investigation, answered the question this way back in October:

Disturbingly, many of the people who are going to such lengths to obtain inside information for a trading advantage are already among the most advantaged and privileged and wealthy insiders in modern finance.

In another word: greed. I don’t care if you call it greed or the need to feel “like an orgasm” as Danielle Chiesi put it in the Galleon case; these reasons for engaging in criminal behavior remain completely unjustified.  To quote U.S. Attorney Bharara one more time, material and non-public:

inside information is a form of financial steroid. It is unfair: it is offensive; it is unlawful; and it puts a black mark on the entire enterprise.

It just goes to show you that rich traders on Wall Street aren’t necessarily rich because they are smarter than the rest of us; they could just be better cheaters than we are. I’ve never thought that hedge-fund investing made much sense for most people, and these insider trading allegations just confirm my opinion.

Hedge Funds Underperform Index Funds

Consider this: even with their cheating, hedge funds haven’t beaten passive index investing!  Hard to believe, but an Ibbotson Associates study found that between 1996 and 2005, hedge funds returned only 8.98% annually compared to the 11.58% annual return of the S&P 500 index. Although the study found that hedge funds do generate alpha of about 3 percent annually, the high management and performance fees charged to investors more than ate up this alpha. In fact, a 2009 study concluded that when you include the higher trading costs and tax liabilities hedge fund investors are exposed to, hedge funds would need to outperform index funds by 10 percent annually just to break even! 

Furthermore, hedge funds don’t provide much diversification to equity portfolios. Strange, given that their name implies a “hedge,” but a 2008 study found a very high 70% correlation between hedge fund performance and the S&P 500 index. Diversification is a critical component of proper asset allocation (see our free report), and the study concluded that investing in real estate investment trusts (REITs) and commodities is a much better way to achieve portfolio diversification than investing in hedge funds.

Warren Buffett’s Anti-Hedge Fund Bet

As some wise sage once put it, hedge funds aren’t an asset class but a compensation structure aimed at fleecing investors. A 2% asset management fee plus a 20% performance fee is just plain obscene.  On pages 18-19 of Berkshire Hathaway’s 2005 letter to shareholders, Warren Buffett wrote that investing in hedge funds is a very effective way to “minimize investment returns.” I urge you to read his story about the fictional “Gotrocks” family that becomes the “Hadrocks” family; it is an investing classic.

Buffett has put his money where his mouth is. In 2007 he bet Protege Partners, a hedge fund manager, $1 million that between 2008 and 2017 the S&P 500 index will beat a fund of hedge funds.

Personal Finance Finds Stock Market Winners the Old Fashioned Way

If you want an investment advisor who, in SEC Enforcement Chief Robert Khuzami’s words, is an “astute student of company fundamentals and marketplace trends,” give Elliott Gue’s Personal Finance a try.

Personal Finance is composed of an all-star team of analysts that beats the market by providing penetrating bottom-up analysis of public financial information as well as top-down analysis of industry trends. 

The editors of Investing Daily fervently believe that all of us can earn a healthy investment return honestly through education and hard work. Personal Finance is our flagship investment service devoted to this proposition. Let’s leave insider trading to the high-fee hedge funds.