Raj Rajaratnam the boss of Galleon, a hedge fund in New York was arrested on Friday for being the mastermind of an insider trading network. That network included people in other hedge funds, private equity funds, consultants and corporate executives – all involved in trading insider information on public companies for profit.
In my four years at Gridstone, I met many hedge funds on sales calls. We offered a research platform with deep data on public companies which should have been of interest to any analyst who invested in public companies based on their fundamentals. But slowly I realized that there were very few in the hedge fund world that actually researched companies to any depth. Most just “traded the news” or were what is called “momentum traders”.
There were reasons for this. Understanding companies requires time and application. At about twenty companies in one or two industries, you start hitting the ceiling of what is possible for one analyst to cover. Hedge funds often don’t have the assets to be able to afford that many analysts.
But I think the real reason is that it is too damned difficult to beat the index just analyzing companies based upon publicly available information. Everyone is seeking an informational edge over the market. Some of this edge is through channel checks and such legal but proprietary sources. Much of it is through rumors – legal but quasi-public. And some of it is through insider information.
Informational edge is a slippery slope at the bottom of which lies insider information – the most alpha-producing informational edge. If you are a high achiever like most hedge fund managers are, and you have profited from proprietary information in the past, it is almost irresistible to cross the line. It doesn’t help that the difference between the difference between a rumor and insider information is only in how the information was procured. A rumor very well could have started its life as insider information. On large caps, placing a bet that is significant for the fund but small enough to escape being noticed is not too difficult. My belief is that insider trading is far more common than what one major bust every few years will make it seem like.
For Raj Rajaratnam and Danielle Chiesi this was about their hedge funds’ performance. But why did Anil Kumar and Rajiv Goel get involved in this? Perhaps the price of admission to invest in Galleon – which was ironically a fund whose performance was based on insider trading – on their tips.
The other irony here is that two of the major players in the insider trading ring are of Indian origin. So is the prosecuting attorney – Preet Bharara – US attorney for the Southern District of New York.