Hedge Funds: Is the Sun Setting on the Raj?

It's not surprising the jury today found Raj Rajaratnam guilty of 14 felony counts stemming from accusations of insider trading. After all, the government had him on tape. Prosecutors love tapes. What the tapes show is that: (a) the defendant and alleged tipper actually had a conversation--it wasn't just chit chat with a secretary; (b) the conversation took place at a time when the defendant could have taken advantage of any nonpublic information he received to trade profitably; and (c) the conversation wasn't just about the Mets, or the best recipe for mac and cheese, or the latest on the width of ties; and (d) the conversation involved the company whose stock the defendant allegedly traded on the basis of inside information. Defense lawyers can and will strenuously argue about what the parties to the taped conversations meant when they said whatever they said, and whether or not that information was already public, etc. But the tapes remove a lot of the doubt prosecutors need to overcome in order to get a guilty verdict.

Rajaratnam has promised to appeal. Apparently, he's going to argue something along the lines that the government can use its wiretap authority to nab old guys who walk around Brooklyn in bathrobes, but not Wall Street guys who live at fancy addresses in Manhattan. At least, that's how the argument on appeal might end up sounding. Would the judges in the appeals court be seen as traitors to their class if they uphold the verdict? Rajaratnam reportedly is rolling in dough, so he has little to lose by appealing ad infinitum. But convicted criminal defendants don't have a high rate of success on appeal. Maybe Bernie Madoff will some day have a neighbor with whom he can talk shop.

More importantly from a systemic standpoint, this verdict may contribute to a downturn for the hedge fund industry. It's not an accident that the current wave of insider trading cases, and the last big wave of insider trading cases, both took place during eras of market stagnation. The Dennis Levine-Ivan Boesky-Michael Milken string of cases had its origins in the insipid stock market of the 1970s and early 1980s. When a market is devoted mostly to flatlining, buying-and-holding and other such investing-for-Main Street mantras don't work. They need a rising market to provide returns. What can be highly profitable in such circumstances is insider trading. Dennis Levine, one of the first high-profile Wall Streeters to be nabbed, turned about $40,000 into $12 million in some eight years. Even if you don't adjust for inflation, that's impressive. (The inflation adjusted figures are an initial investment of about $137,000 becoming roughly $24,467,000.) Insider trading pays, as long as you're not caught.

Since the spring of 2000, the stock market has, adjusted for inflation, dropped. Okay, it's bounced down and up and down and up again. But adjusted for inflation, it hasn't returned to its 2000 peak. In such circumstances, with investors having high expectations for hedge fund results (appropriately so, given the steep management and performance fees they face), hedge fund managers are under the gun to deliver. But things haven't been like the 1990s, when a cow that bought and held would have made a lot of money. Thus, the temptation to seek out and trade on inside information.

The recent spate of insider trading cases, most of which seem to involve wiretaps, confirm that the allure of inside information remains strong. For quite a few defendants, it's proven to be a siren call. Hedge fund managers, whatever they may have been up to, will probably cool their jets. Some phone calls may not be answered; others not returned. Swapping tips to make some money today isn't worthwhile if the true price is you end up a guest at a federal facility, swapping tips with Bernie Madoff. Hedge fund returns could droop.

Hedge fund investors may start to yank their money. Most don't want to be associated with even a whiff of scandal. Moreover, if a fund they invest in is caught up in insider trading, they might have to return some of the distributions they receive so other investors, injured by the insider trading, can obtain recompense. This is what happened to some of Bernie Madoff's investors, who received distributions exceeding their investments and had to return some of the money.

Even if a hedge fund hasn't been charged or isn't rumored to be under investigation, its returns might diminish because managers stop having some of the edgier conversations they've had in the past. Not to say that they were or will do anything illegal, but not all risks are worth having to bunk with Bubba. The lower returns, though, may lead their investors to seek greener pastures elsewhere.

Money has surged into the hedge fund industry during the past year, with investors trying to recoup losses from the recent financial crisis. The hedgies have done well, since the Federal Reserve keeps shoveling shiploads of cash off its loading dock to boost stock and commodities prices. Hedge fund managers have reigned supreme while investment banks battled increased regulation. But the Fed is being circumspect about how long it will keep its money printing presses rolling. Inflation is rising. Asian and European economies are slowing. Commodities prices have suddenly ebbed. There are plenty of market-related reasons to think that asset prices may have peaked. Then consider that federal wiretapping is probably cutting off the flow of inside information to some of the more brazen hedge fund managers, and chances are growing that the sun may be setting on the hedge fund industry, at least for another market cycle.