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How Did Major Hedge Fund Earn 30% Returns for 20 Years Straight? Lots of Cheating

There are 8,000 hedge funds, and they are up to their eyeballs in unethical behavior.
 
 
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How would you like to invest $10,000 and watch it grow over 20 years into $1,461,920? Well that's what happened at the giant hedge fund, SAC Capital Advisors, which made a 30% return for 20 years in a row.  

How is it possible to make such profitable investments again and again and again? The U.S. Attorney for Manhattan, Preet Bharara, believes he has the answer: SAC is cheating ... again and again and again. In fact, Bharara suggests that hedge funds that engage in insider trading may be rotten to the core:  

"Given the scope of the allegations to date, we are not talking simply about the occasional corrupt individual; we are talking about something verging on a corrupt business model, for the defendants seem to have taken the concept of social networking and turned it into a criminal enterprise. " [refers to a 2011 hedge fund indictment, not the current case against SAC.]

To date, nine current and former SAC employees face insider trading criminal charges stemming from their work at the firm. Four have pled guilty and two are still fighting their indictments. Now the head of SAC, multi-billionaire Stephen A. Cohen (note the initials), will be subpoenaed to appear before a grand jury. The federal strategy may be to indict the entire hedge fund and shut it down, according to the New York Times.

We do not know as yet to what degree SAC relied on illegally obtained information (or other illicit activities) to amass its extraordinary profits. But we do know this: hedge funds don't like to gamble. Rather they want to make their billions by betting on sure things. In researching my book, How to Make a Million Dollars an Hour, it became clear that that the hedge fund industry as a whole is up to its eyeballs in a series of unethical maneuvers that sometimes are legal, sometimes are borderline and often are outright criminal.

But aren't there many (some?) honest and ethical people working in America's 8,000 hedge funds?  

Maybe so, but the overwhelming culture within hedge funds makes cheating a way of life, according to Lynn Stout of UCLA Law School. In her article, " How Hedge Funds Create Criminals," Stout claims that hedge funds flash three critical signals that promote unethical behavior:

Signal 1: Authority Doesn’t Care about Ethics. Since the days of Stanley Milgram’s notorious electric shock experiments, science has shown that people do what they are instructed to do. Hedge-fund traders are routinely instructed by their managers and investors to focus on maximizing portfolio returns. Thus, it should come as no surprise that not all hedge-fund traders put obeying federal securities laws at the top of their to-do lists.

Signal 2: Other Traders Aren’t Acting Ethically. Behavioral experiments also routinely find that people are most likely to “follow their conscience” when they think others are also acting prosocially. Yet in the hedge-fund environment, traders are more likely to brag about their superior results than [about] their willingness to sacrifice those results to preserve their ethics.

Signal 3: Unethical Behavior Isn’t Harmful. Finally, experiments show that people act less selfishly when they understand how their selfishness harms others. This poses special problems for enforcing laws against insider trading, which is often perceived as a “victimless” crime that may even contribute to social welfare by producing more accurate market prices. Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

 
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