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.
6 am pacific 
Basab
Nice observation about the redundancy of company research to generate alpha. I have observed the same tendency with both gamma-positive funds and long-only houses. Now, if publicly disclosed information ceases to impact asset prices (either by their info-staleness or due to analysts perceiving them as valueless) then does that move the markets – in a macabre manner – towards being efficient where random news is only what moves the market? Also, where does all this leave research as a function – does sell-side research finally die in its current form and buy-side research treads dangerously the line between public and insider information?
Sincerely
Subrata
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Basab,
Interesting observations. Though when you say "two of the major players in the insider trading ring are of Indian origin" you don't mean to include Raj Rajaratnam; right? He is of Sri Lankan Origin, technically of Desi origin, but not "Indian"
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Mohan – the other player was Goel of Intel Capital.
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Very interestingly, there are some people that are actually making a case for insider trading to be made legal. This was on the WSJ today. I can't bring myself to agree with this viewpoint but they do raise an interesting point about "insider non-trading". Their argument is that inside info leads to both profitable trades and "non-trades" i.e. a decision by someone to not make a trade they would have otherwise made. It is almost impossible to nail those. Assuming that only a fraction of insider trades are caught out and non of the non-trades are, their point is that the financial system is non the worse for all of this.
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Bharat – do you have a link to this news. On the face of it it seems loopy. Does that make it OK for senior execs at public companies to divulge non-public information for a profit?
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It probably is not a bad idea to legalize insider trading, especially if it already is happening under the table. Here are some thoughts.
The only cases where non-public information can be divulged for a profit is when there is an expected rise or fall in the stock price and associated profit or loss booking by the investors. If this process is legalized, the execs will be bidding the news to the highest bidder – now there is no confidante! The bidding process itself can be rationalized over a period of time – basics of group theory tells us that the group will find a reasonable price for the news and that price will not be more than the value the news carries (in terms of the return it will get). Most institutional investors will be good enough to bid and get the news at whatever price is rational. Alternatively, the execs might just trade it for themselves.
The question is, what happens to the individual retail investors? They will be the ones who will end up making the losses every time an insider information has been traded. But so will all the other big guys who could not get the news first. Also, with the amount of insider trading already happening today, are they not already making losses?
Another theory that can be tested is on the fact that the demand of these insider news items is probably because they are not legal. This prevents the law abiding execs from sharing these news items. If divulging of non-public information is legalized, the number of sources for the same news will significantly increase making some of the news as "near-public information".
Ofcourse, the larger questions around ethics and equal access to information still exist.
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This was in last week's weekend journal (print version). Can't seem to find the online link – I am not an online premium subscriber, maybe that's why. It basically built upon Milton Friedman's endorsement of insider trading and made a few other points.
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I found it later. Look at my comment just above yours 🙂
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Nimit – there was a piece in the Wall Street Journal that made a similar point. Here's the link http://bit.ly/2wO770
This notion is attractive to economists and I do understand how this will create a 'truer' price for the company's stock which is an attractive proposition in many ways. However, practically I don't think this works. Here are a few reasons:
The fundamental premise of insider trading laws is to preclude trades where one side has access to more information about the company than the other side. If insider trading was to be made legal, insider's would very often be on one side of the trade with more information than any outsider. Insiders trading (or profiting from insider information by selling it to other traders) has unintended consequence like
a/ Public disclosure by companies actually comes down
b/ Execs spend much of their time trading the company's stock because it is more profitable than their compensation
c/ Execs or sales people have a moral hazard – they could through their actions cause the stock to plunge after selling it short. (a CEO could resign, a sales guy might lose a big deal)
Besides all these practical difficulties, it is politically impossible.
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