By Wade Slome, CFA, CFP
Information is power and some hedge funds, mutual funds, and investment managers will go to great lengths to obtain the lowdown.
Integrity of the financial markets is key and recently several hedge funds (Level Global Investors LP, Diamondback Capital Management LLC and Loch Capital Management LLC) have been raided by the Federal Bureau of Investigation (FBI). Other large investment players, including SAC Capital Advisors, Janus Capital Group Inc. (NYSE:JNS) and Wellington Management Co. have also received inquiries as part of what some journalists are calling rampant industry insider trading activity. Even investment bank Goldman Sachs (NYSE:GS) is allegedly being examined for potential unlawful leakage of merger information. Little is known about the allegations, so it is difficult to decipher whether this is the tip of the iceberg or standard investigative work.
Regardless of the scope of the investigation, there is a fine line between what scope is considered fair versus illegal. The distinction becomes even more difficult to pinpoint with the evolution of faster and more voluminous trading (i.e., high frequency trading).
The internet has accelerated the speed of information transfer faster than a politician’s promise to cut spending. Data is chewed up and spit out so quickly, meaning tradable information has a very short shelf life before it is profitably exploited by someone. In the old days of snail mail and private back-office meetings, security prices would require time for information to be completely reflected.
Expert Networks Questioned
Another ingredient introduced over the last decade is the advent of the “expert network,” which are firms that connect fund managers to industry specialists, in many cases as part of a “channel check” to gauge the health of a particular industry.
About 10 years ago, Regulation FD (Fair Disclosure) was introduced to prevent selective disclosure of “material non-public” information (tips that will likely cause security prices to go significantly up or down) by senior company officials and investor relation professionals to investor types. Greedy (and/or ingenious) institutional investors are Darwinian and as a result figured out a loophole around the system. Hedge funds and other investment managers figured out if the senior executives won’t cough up the good info, then why not target the junior executives and squeeze the inside story from them like informants?
Expert networks serve as an informational channel to service this demand. Although I’m sure there have been a minority of cases where mid-level managers or junior executives have leaked material information (intentionally or unintentionally), I’m very confident that it is the exception more than the rule. In many instances when the beans were spilled, Regulation FD protects both the person disseminating the information and the investor receiving the information.
Rigged Game for Individuals?
OK sure… hedge funds and institutional managers may occasionally have privileged access to executive teams and can afford access to industry experts. I should know, since I managed a multi-billion fund and consistently had access to the upper rank of corporate executives.
Hearing directly from the horse’s mouth and trying to interpret body language can provide insights and instill confidence in a trade, but these executives are not stupid enough to risk prison time by selectively disclosing material non-public information. This dynamic of privileged access will never change as long as CEOs and CFOs are allowed to communicate with investors. Corporate executives will naturally prioritize their limited investor communications towards the larger players.
So with the big-wig managers gaining access to the big-wig executives, has the game become rigged for the individual investors? The short answer is “no.” Over the last decade individual investors have experienced a tremendous leveling of the playing field versus institutional investors.
While institutions have privileged access and have pushed to exploit HFT and expert networks, individual investors have gained access to institutional quality research (e.g., SEC filings, real-time conference calls, Wall Street reports, etc.) for free or affordable prices. With the ubiquity of technology and the internet, I only see that gap narrowing more over time.
There will always be cheaters who stretch themselves beyond legal boundaries and should be prosecuted to the full extent of the law. However, for the vast majority of institutional investors, they are using technology and other tools (i.e., expert networks) as shrewd resources to compete in a difficult game. I will reserve full judgment on the names pasted all over the press until the FBI and SEC reveal all their cards. So far there appears to be more noise than smoke coming from the barrel tip of the insider trading gun.