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.

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.

Allow Insider Trading? Why Not Reduce Inside Information?

With the filing of the government's insider trading case against Galleon Management and diverse and sundry individuals, free market de-regulators have again piped up with time-worn arguments for legalizing insider trading. The essential premise of this thesis is that insider trading moves the market price of a company's stock toward the level at which it would trade if the inside information were publicly known. In this way, the information is "broadcast" through price movements in the stock, and buyers and sellers interact at "fairer" prices.

There are market problems with this proposition. Days or weeks can pass before the accumulated impact of the trades by knowledgeable players pushes prices to the level warranted by the undisclosed news. Along the way, a lot of trading at unfair prices could take place. Trades totaling hundreds of thousands or even millions of shares could be done at prices that favor insiders and disadvantage those left in the dark. Publicly announced news is widely known and produces almost instantaneous price movements. Public disclosure produces much fairer prices much faster, and everyone has the information needed to judge the fairness of the price.

In addition, insiders can have more than one reason for trading. A CEO may sell stock to cover a child's college expenses, or to build a vacation home. Sales don't necessarily mean something negative is happening at the company. Buying stock may indicate optimism about the company's future, or be a defensive measure against short sellers when the company's fortunes are known by the CEO to be dim. The mere fact of transactions, and the price movements they induce, may mislead instead of inform.

A little history is worth noting. Long before the SEC interpreted federal law to prohibit insider trading, state law prohibited it (see Strong v. Repide, 213 U.S. 419 (1909), a U.S. Supreme Court decision that interpreted state law to prohibit a corporate insider from taking advantage of nonpublic inside information in dealings with an uninformed shareholder). The state courts, before the SEC was created, were hesitant about applying this insider trading prohibition to anonymous trading on an exchange. However, it's likely that sooner or later an aggressive state official like, randomly speaking, the attorney general of New York, would convince state courts to enforce the prohibition in exchange-based trades, which today comprise the bulk of securities transactions. Realistically speaking, insider trading would probably be unlawful under state law if the SEC and U.S. Department of Justice ignored the issue.

Even the branch of federal insider trading law called "misappropriation" would probably be illegal under state law if it weren't part of federal law. Misappropriation refers, in essence, to trading by someone who isn't a corporate insider but has a fiduciary or contractual duty of confidentiality to refrain from trading on nonpublic information. The classic example of misappropriation comes up in the area of mergers and acquisitions. Let's say an activist shareholder decides to take a run at a company he believes to need the benefit of his activism. He hires an investment banker to provide advice and, potentially, financing for a takeover offer. The investment banker secretly buys the target company's stock through a foreign bank account in anticipation of the moment when the activist shareholder surfaces publicly (almost sure to be a market moving event). The banker's trades push up the price of the stock. The activist shareholder wants to prevent this kind of trading because it could increase the cost to the activist of purchasing stock, particularly in a potential takeover of the target company (since offers to purchase companies almost always come at a premium to the open market price of the stock). Activist shareholders typically expect and require their advisers and financiers to avoid trading in the stocks they target. If the federal government didn't enforce this obligation as misappropriation, state courts could easily enforce it as a breach of contract. Many millions and even billions of dollars are at stake, so activist shareholders and other potential acquirers of companies wouldn't let the problem rest. They'd enforce their contracts in state court if the SEC and DOJ weren't already on the beat.

Bashing the federal government for pursuing insider trading is misguided and an exercise in futility. But the Galleon case, with its many tentacles, reminds us that insider trading won't die as long as there is inside information. We know from recent experience how volatile the stock market can be. Inside information is about as close to a sure bet in stocks as is possible. That's why market players lust for it. Government enforcement provides some deterrence, but will never stamp it out entirely.

An intriguing and potentially more effective way to reduce insider trading is to speed up public disclosure of inside information. The less nonpublic information there is, the fewer the opportunities for insider trading and the fairer the day-to-day trading in the markets. Public companies today report their financial conditions quarterly and annually on SEC reports called 10-Q and 10-K. A few special events must be reported on SEC Form 8-K whenever they occur. But there is nothing like continuous disclosure. (Stock exchange rules do require listed companies to disclose all "material" developments, but the exchanges use these rules to require disclosure of developments only after funny trading is observed in the company's stock, and not to require immediate and continuous disclosure of all material developments.)

The quarterly and annual system of financial reporting was created in the 1930s and 1940s, when accountants used desk calculators (bulkier and heavier than many of today's laptops) to tally up companies' accounts. The sheer amount of time required to manually add, subtract, multiply and divide necessary to produce a company's financial statements made more frequent financial reporting difficult or impossible.

Today, electronic computing power abounds. Laptop computers can create hours of video. That's enough computing power to assemble a company's financial statements. Many companies calculate their operating results on a daily, weekly and/or monthly basis. Fast food and casual restaurant chains, and retailers are especially adept at this, since serving the fickle public is at the heart of their businesses and they need to monitor trends in product sales by the day. Since they use this information to manage their businesses, it must be pretty reliable. Why not put shareholders in the loop?

Companies generally make decisions about bad debts and other asset writedowns and writeoffs on a quarterly basis. But that's because the current system of reporting requires quarterly assessments. There's no intrinsic reason why these decisions cannot be made more frequently than once every three months. Debts go bad every day and recognition of uncollectability doesn't have to be delayed until the end of the quarter. Similarly, depreciation, depletion, and additions to or subtractions from reserve accounts are not intrinsically quarterly or annual determinations. They, too, can be made more often as relevant information permits.

Disclosure by public companies of at least some financial information could be made more frequently--monthly, weekly and even daily. Of course, the more frequent the disclosure, the more preliminary it's likely to be. But the current system of reporting already involves disclosure of preliminary information. The quarterly reports on Form 10-Q are preliminary as compared to the annual report on Form 10-K. A more continuous system of reporting would simply involve a greater degree of "preliminaryness." Just as investors have grown to understand the preliminary nature of quarterly reports, they can adjust to the preliminary nature of more frequent reporting.

Of course, financial reporting is a complex subject and any system of continuous reporting would have to be implemented over the course of enough time for both companies and investors to adjust. But there is nothing intrinsically impossible about it. Indeed, the SEC already requires continuous reporting of potential market moving information in another setting.

Shareholders controlling, individually or as part of a group, 5% or more of the outstanding shares of a public company are usually required to report their holdings on an SEC form called Schedule 13D. This schedule calls for the disclosure of a variety of information items, such as the identities of the shareholders in any group, any and all of their contracts, agreements, and understandings with respect to the stock, their plans, proposals and intentions with respect to the company (which most importantly include any intention of trying to take over the company), and their sources of financing. This is sensitive, market moving stuff, and 13D persons are required to promptly disclose in amendments to their filings any changes to these and other informational items. Promptly generally means no later than the next day--not quarterly, not annually.

Thus, the federal securities laws apply the concept of continuous reporting already, just not to public companies. 13D persons don't have to file financial statements, and public companies do, something that would make continuous reporting a much bigger undertaking for public companies. But lest we obsess over costs, and not benefits, consider a stock market with less insider trading, fewer missed analyst estimates, less stalking of companies by whisper numbers, fewer quarterly surprises for outsider shareholders, and fairer prices on a continuous basis. The current system of quarterly and annual reporting was the Glenn Miller era's response to the paucity of corporate reporting of even earlier times. We no longer use the manual typewriters and desk calculators of the 1930s and 1940s. There's no reason why we should keep using that era's financial reporting system.