Will Hedge Fund Returns Drop?

The last couple of years have seen aggressive enforcement of the insider trading laws by the U.S. Department of Justice and the SEC. The use of wiretap authority has given federal prosecutors a powerful tool not deployed in years past, and greatly amplified investigators' ability to uncover illegal tipping. It seems that, almost every month or two, another hedge fund or traders associated with hedge funds, plead guilty, settle civil charges or both. Entire networks of tipping and insider trading have been blown up.

Traders at surviving hedge funds have no doubt taken notice of the downfall of many of their peers. Those that were dancing at the edge of the curb, or beyond, may well be cooling their jets. Many phone lines on Wall Street are probably less busy these days.

Competitive pressures were doubtless a major reason for hedge funds to engage in insider trading. If a hedge fund that takes 2% of a customer's assets and 20% of gains wants to stay in business, it has to beat the S&P 500 by quite a lot. That's much more easily said than done in the secular bear market that has existed since the stock market downturn in 2000. Inside information offers an edge that can't be beat (as long as you're not caught), and many hedgies just couldn't resist the temptation have a soto voce telephone conversation or twenty-six.

However, explaining lame returns to dissatisfied investors is a lot better than sharing a cell with Bubba. Even if you lose your investors, you don't have to clean latrines used by a lot of other guys. With it likely that many fewer "just between you and me" conversations are taking place on the Street, one must wonder whether hedge fund returns will drop. If you're an accredited investor, or managing money for one, you naturally don't want your money involved in illegality. But you also might ask yourself what returns hedge funds might offer now that federal electronics are policing the markets. A guy who wants 2 and 20 needs to be pretty talented in order to legally make the returns that justify a hedge fund investment, especially with that industry crowded with firms competing for the special profits that economists call "rent" (meaning profits above the level that a competitive market would provide). Think carefully before locking up your money in a hedge fund.