It’s darn near impossible for an investment manager to beat the market once you adjust performance for risk and fees. Every quarter, when Morningstar shows its fund reports, more than half of all funds prove to be laggards after adjustments. We all know that Warren Buffett can beat the market because he’s pretty much the only person who can. Bernie Madoff lied. And Raj Rajaratnam allegedly traded on inside information.
Even then, it does not seem to have helped him much. The Galleon Group of hedge funds, which Rajaratnam managed, has shut down in the wake of insider trading charges against Rajaratnam and several associates. However, it doesn’t look like the funds’ performance was all that great, so Rajaratnam and company may base their defense on the fact that they did not make excess profits. One of the charges is that Galleon made $500,000 trading in options in Google after receiving a tip from an employee of Google’s investor relations company that earnings would be lower than expected. To make that profit, an inside trader would have to identify informants, figure out how to reach them, compensate them, act on the information, and take the risk that it was good information. These steps involve time and expense that cut into the profits from insider trading. The profits have to be huge to overcome the costs, and they may not be big enough to compensate the inside traders for the risk. And then, of course, the information has to be good. A wise inside trader would probably sit on the first few tips just to see if the tipper has good information. But even a tipper with mostly good information will have a few duds.
All that, for a $500,000 profit (before expenses) in a group of funds with $3.7 billion in assets. That works out to a 0.01% return. A fund manager needs hundreds and thousands of these bets to beat the market. It would be easier to be legit.
This case has a few staples of insider trading cases. Two of people mentioned in the charges were junior staffers, one at Moody’s, another at Google’s investor relations firm. These are people for whom $10,000 or so is enough money (a sum mentioned in the SEC’s filing) to compromise their ethics; they may also not know how wrong it is. If an inside trader can find a weak person in these circumstances, there’s a nice profit to be made, at least on one or two trades.
Another staple is the person looking to impress someone else with their great information. A few of the tippers fit that bill, especially Roomy Kahn, a former Galleon employee who seems to have had financial trouble and wanted to be rehired.
Insider trading is also difficult to prove. Martha Stewart seems to have sold her Imclone stock after receiving a call from her broker, which he placed after receiving a call from the daughter of the Imclone CEO. But for all that, Stewart’s criminal charge was obstruction of justice because the Feds could not prove insider trading.
In the Galleon case, the allegations have been enough for the fund to close. The dishonest and honest alike have lost jobs. Many will have a hard time working again because of the taint of the case, even if they were not charged or are found not guilty. The people who have been implicated have to hire lawyers, and others may decide that it’s a good idea to have counsel now in case they need it later.
I’m not naïve; I believe that people trade on inside information. Why wouldn’t they? People buy and sell securities every day, and a few of them may have an edge some of the time. But do they have enough of an edge to produce consistently superior returns? That, I’m not sure about, but it seems unlikely.
The bottom line is that most people should just buy index funds. They won’t beat the market with them, but they’ll do better than most fund managers, and they’ll do it fair and square.