Opinion

Felix Salmon

Why insider dealing is so attractive to hedge funds

By Felix Salmon
June 27, 2011

Danny Black, in a series of comments on my post about Raj Rajaratnam and insider trading, points out how small Raj’s insider profits were, compared to his net worth and the size of his fund:

One of the interesting things is just how [relatively] tiny the sums the insider trader makes. Rajaratnam was worth 1.8bn USD at one point. The upper end of what he made was 60mn. If I told you I could increase your wealth by 3% over a number of years but you might spend a decade or so in federal jail would you take up the offer?

This I think is doubly wrong. For one thing, $60 million is emphatically not an upper bound for the amount of money that Raj made on insider trading. Raj was not new to this game when his phones started being tapped, and it’s incredibly naive to think that all of his insider dealing was conducted, in one way or another, over the phone. $60 million is the upper bound for trades which the authorities considered prosecutable; it’s nowhere near being an upper bound even for what he made while his phone was tapped, let alone what he made over the course of his career.

But even that understates the value of insider trading to a hedge fund manager. Raj made his billions by collecting 2 and 20 from outside investors in Galleon: the path to hedge-fund riches is, always, to maximize assets under management. And if there’s one thing that hedge-fund investors are looking for, it’s alpha — that small edge which the best managers are believed to have over the market as a whole.

To a hedge-fund manager, then, $60 million in excess profits can be worth vastly more than $60 million. If it persuades outside investors that you can generate more alpha than anybody else, and those investors end up giving you an extra few billion dollars to invest as a result, and you take 2-and-20 on those extra few billion dollars, then at that point you’re making real money.

Running a hedge fund, in this sense, is a way of leveraging any insider trades you find many times over. They don’t just make money in and of themselves: they also help you attract all-important AUM. Given that calculus, it’s easy to see why Raj found insider dealing so attractive. Without it, he might never have become a billionaire in the first place.

Comments
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Finally read this NY Times article this past weekend, and what struck me is that a lot of institutions that manage and manipulate private capital can become (and perhaps are really all about?) using social networks to exploit information that is illegal to exploit. It’s no accident that most of the players in the Rajaratnam saga were from the Indian subcontinent — not that Indians are inherently corrupt, of course, but just that this particular social network (and of course there are many others that we don’t know about, originally formed in business schools, fraternities, pickup basketball leagues, whatever) formed in the first place out of Indian immigrants who worked in the finance and tech industry. Rajaratnam was able to see that there was a lot of profitable information in the network and he exploited it.

Posted by jfruh | Report as abusive
 

Without knowing the ins and outs of Wall St. trading, I think you are right. It is not really the magnitude — or lack of — that counts when someone’s malfeasance is exposed.

There is a comparison with politicians’ sex scandals. The normal response tends to be: “Why jeopardize so much for so little?” The probable explanation is that there is a pattern of private conduct that was manifested long before its effects bore such public consequences.

Posted by jbernar | Report as abusive
 

Where’s my hat-tip? ;)

Posted by TinyTim1 | Report as abusive
 

The comment by jbernar is the most accurate and sentient I have read on this oft visited web site. It describes to a T the code of conduct inherent in the Wall Street and D.C. population. My only lament is that most of them will not see it, those who do will be convinced it does not apply to them, and the rest of the population, in their eyes, is not of sufficient status to halt it.

Posted by bentwing60 | Report as abusive
 

Great post Felix,

Spot on… a few years of great performance numbers in the early going are worth a huge multiple of the actual money made on the trades themselves because the good numbers draw in investors like a magnet.

The real question is why on earth did Raj continue with the shady tactics. Once you’ve got a billion bucks of your very own NOTHING is worth the risk of spending one night in the slammer.

Raj wasen’t the first screwball to roll the dice when he didn’t have to. I can totally understand why a marginal baseball player like David Ortiz (who hit .234 the season he was age 25) takes steroids to turn himself into an allstar and make a 100 mil. What I can’t for the life of me figure out is why a serial allstar like Bonds who was already well along in the process of earning his 100 million and a trip to the Hall of Fame would decide that he wanted to taint all his achivements for an extra 150 homers and an extra 50 million.

Someone close to Raj or Bonds should have told them about the theory of deminishing returns. Your first million is a real big deal, your 10th million is still pretty helpful, your 101st million dosen’t change much at all.

Posted by y2kurtus | Report as abusive
 

But you don’t understand the mentality of the rich. The first million you have arrived, the second million you are set and all the rest you are keeping score! George Soros is wealthy beyond all imagination and yet he will bring down the country to add to his wealth and control of a failing system regardless of the conquences to the average American!

Posted by bentwing60 | Report as abusive
 

If you read the prosecution it wasn’t based on phone taps. Thats how they got people to talk. It was based on IM messages, data on hard drives and testimony.

I was being kind when i said the upper bound on the amount going directly into his pocket was 60mn, because if you are talking about him getting 2 and 20 on the amount in the fund and the incremental bump to his funds performance vs the incremental bump to his personal funds then the figures look worse for you. He was running a 7bn dollar fund so 60mn more is a bump of less than 1%. His 2 and 20 take home would be 13mn, not 60mn.

I think you fundamentally misunderstood my point. I was not attempting to clear this guy, who is a proven crook. You were originally claiming that insider trading was endemic, a claim which is untrue. Not because people in the business are cuddly but because there simply is not enough money to be made to make it worth while. Firstly, there tends not to be many surprises in publically traded companies because most of the info is public and they have huge teams of people whose job it is to make sure there are no surprises. Secondly, even if you did have that information it is not trivially obvious how the market is going to react to it. Finally, most people trade in an information insensitive manner. The majority of asset managers are either index funds or quasi-index funds and then you have people trading off technical factors. So take the tiny percentage of people doing fundamental investing and take the percentage of cases where there are shocks to the market and it should be obvious that insider trading simply does not play a big factor in the market.

I will offer an alternative explanation for why this guy did this and that is simply he didn’t like to be wrong and liked the aura of being omniscient.

Posted by Danny_Black | Report as abusive
 

wasn’t just based on phone taps

Posted by Danny_Black | Report as abusive
 

TinyTim1, so your argument is that people flocked to Galleon because it made 22% instead of more than 21.15%?

Posted by Danny_Black | Report as abusive
 

The only insider trade I am aware of that made serious coin was when the government let Ivan Boesky liquidate his holdings before announcing he was going to prison.

Posted by Danny_Black | Report as abusive
 

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