Inside Men

Crikey. Looks like they’re going after Stevie Cohen now. For context, SAC Capital is the leading hedge fund of our time. They get to charge not 1 and 20, not 2 and 20, but 3 and FIFTY to their punters. And like La Gavroche, they get to decide who gets in; most of the funds are closed, with waiting lists up the wazoo. They’ve done this through nothing but creating consistent, (suspiciously?) persistent, 20% plus returns a year for god knows how long. SAC is the “smart money” you would follow if you knew where it was going; Baruch has known traders do that, no questions asked. And why? Because you just reason that they know something; they always do. How ominous that sounds now.

If SAC goes down like Galleon did it’s a much much bigger deal. I don’t mean the trading impact on the market, although there might be some — SAC is a rapid-fire trading house and will likely be positioned in mostly highly liquid securities. What I mean by a bigger deal is in an Ivan Boesky sort of way, a Drexel Burnham Lambert, a Defining Moment of Wall Street Greed sort of thing. A number of awful mini-series will be made about it. It may even turn out to be worse than that.

It’s clear too, the other half of the vast conspiracy (should it be proven to exist, of course) lies among technology stock executives, at least among those high enough up the chain to know the numbers. So far, at least, executives at IBM, Intel, 3Com, Atheros, and Polycom are supposed to involved. This is a highly representative list, across many tech subsectors and market caps. It’s not unreasonable to think staff at other companies are going to be indicted. Galleon’s original investors seem to have been tech executives who used to talk to Raj when he was a sell-side analyst, ie his sources, his informal “channel checkers”. Even if no brown envelopes changed hands initially, secretly advising a fund you have invested in p.a. on sensitive stuff doesn’t seem a stretch on the part of the executives, especially if it took place before RegFD. The relationships may have then become formalised, secrets in exchange for cash — is it unreasonable to imagine that the original conflict of interest sowed the seeds of the greater, and more obvious crime later on. If I was one of the Feds working the case I would view identifiying the early and later investors in Galleon as an avenue of enquiry rich, shall we say, in possibility.

Now it’s not just Galleon involved, but a horde of satellite hedgies with obscure names, and some of the managers who have started to cooperate with the authorities seem to have worked at SAC. “People familiar with the matter” (ie most likely the prosecutors themselves) have told the WSJ that SAC are the ones they’re gunning for. Given the size of the target, the prosecutor who can pull off this one is, on past form, a dead cert to be mayor of NYC, or at least state governor, and eventually will have the chance to become a cross-dressing presidential candidate.

If indictments are really going to be sent out, a number of half-formed thoughts spring to Baruch’s mind:

  1. this is grist to the mill of the “you can’t make money in the stock market crowd”, the Felix Salmons of this world* who would have us all invest in index funds and ETFs. This is terrible, not just for people like me who depend on belief that a small number of gifted investors are capable of consistent, though not necessarily persistent, returns. No, it also, reductio ad absurdiwhatever, will make the stockmarket less liable to make any distinctions between companies whether they be good ones or bad ones — the very life force of capitalism itself
  2. highly successful “fundamentalist” hedge funds may now have to spend as much time excusing suspiciously excellent performance, just as more unfortunate ones have had to traditionally spend time explaining away bad returns. In many cases this may be difficult, as the successful ones no doubt touted their “informational edge” as a way of getting the investors in in the first place.
  3. because of this I can’t decide whether this is good for us honest fundamental investors, or bad. At worst, the boundaries of what we consider ethically and legally acceptable may stray. What we could call the “brown envelope” investment strategies are clearly not kosher, but what about ones where legitmate “homework” brings about the same result? How exactly is a sell-side channel check, communicated to a limited number of paying clients, conceptually different? Insider trading as a concept does not have hard edges, and innocents may get caught up in the net, or much worse, be encouraged to stop doing any digging at all. Maybe investors will conclude that all the fundamental investment strategies are at risk, and eschew the class altogether in a “kill them all, god will know his own” sort of way. At best, however, the money invested in dodgy funds may find a home with more honest practitioners, and, much more to be hoped for, fund investors themselves may reset unrealistic expectations for consistency of returns. Larger drawdowns will become more acceptable, as will greater volatility in monthly and quarterly track records. In other words, expectations will become more in line with what the real world actually doles out.

* of course, Felix Salmon has many other opinions, some of which are even correct.

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4 thoughts on “Inside Men”

  1. What a load of shite. The “dont investigate the hedge funds with consistent returns ” argument is nonsense. If they have a good methodology, they can explain it. If they have done something dodgy a la Galleon, then they deserve to get hammered. This is a variant on the bankers’ argument for big bonuses now to retain top talent when the top talent ran the bbanks into the ground. You should be ashamed of this nonsense.

    1. I don’t believe I made that argument. I actually think super consistent returns should be a factor that leads to more scrutiny. What did I say to give you the opposite impression?

  2. What you’re really saying is that “it” is a slippery slope.

    The operative phrase repeated by counsel (off-the-record in the confines of a secure recently-swept room) time and time again must be:
    P-l-a-u-s-i-b-l-e D-e-n-i-a-b-i-l-i-t-y.
    If you’re shorting a stock where you’ve got primo info – be prudent and short a basket; if you know someone is going to be taken out, be sensible and buy it AND its nearest neighbors. Yes it waters-down the returns, but at least you’ve got plausible deniability. On the other hand, if you’re greedy, and instead you decide buying 1000 way way O-T-M calls in the near month is the way to play it, you get what you deserve, or deserve what you get (when in front of the magistrate for sentencing).

    One can’t underestimate the importance of the appearance of justice. We (in the rich west) have been living in a charmed age, in context. The subterranean political implications of seeming economic unfairness and injustice spiraling ever-upwards without consequences are real (and increasing). This is not bolshie hyperventiliation, just a reminder that the majority of the population get out of bed in the morning for shit-shovelingly long hours, lack of any semblence of control, lame pay with barely healthcare, often (though not universally) with some remote hope and prayer in mind for them or their children to improve their lot. Rig the game, or sufficiently give that appearance through the “bonus culture”, winner-take-all outcomes, for the further benefit of the wealthy and supremely rich, low-ish marginal rates (relatively speaking) and regressive tax regimes, and it doesn’t take much to imagine NYC resembling a future Sao Paulo rather than anything we’ve seen to date similar major cities.

    It would be so easy to incent people with long-term stock grants that vest over time (and that are accruals, with a claw-back if you blow the place up). It would make so much sense for HFM incentives to represent a fair deal that don;t promote asymmetric risk-taking and shooting the moon, and that vest over longer periods with clawbacks. The fairness issues are all related. I’m with Shiller on the “index the level of marginal rates to the level of overall economic inequality” as something that’s on the right track and a reasonable place to start. Skinning a few cheats in public isn’t bad either…

    (oh yeah, Baruch, check your email!)

  3. I think the critical distinction between real fundamental investors and “poseurs” like Galleon and perhaps SAC is the turnover of their portfolio. If you are a non-quant oriented investor, and you turn over your portfolio more than 2 times per year (I heard Galleon was more like >6x per year), then you are not a “fundamental” investor, you are merely trading sentiment on any given name. Sentiment is driven by perception and nothing drives perception more than unexpected near-term news. That’s why all these hedge fund guys focused just on near-term quarterly misses or outperformance. That’s not fundamental investing of any kind I’m familiar with.

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