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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.

Brilliant Criminals?

The more we dig into what hedge funds actually do, the more we find that insider-trading is just one of many unethical strategies used to rig bets. Their goal always is to find a sure thing. And the only sure way to secure such infallible investments is to cheat.

  • At the height of the housing bubble, large banks colluded with hedge funds to sell mortgage-related securities that were designed to fail so that the hedge funds could collect insurance on that failure. (This is exactly like building a home that will burn down in three months so that you, the seller and builder, can collect the insurance.)

  • High frequency hedge funds set up their super-computers next to the stock exchanges so they get the information a few nanoseconds before the rest of us. This allows them to deploy automated systems to front-run our trades. Between the time you press your E-trade button and the time the trade actually goes through, a high-frequency trader is buying what you want and selling it back to you for a few pennies more. By systematically fleecing stock-market participants, high-frequency traders extract $5 to $20 billion a year from the rest of us.

  • Jim Cramer (host of CNBC's "Mad Money") admits to planting false stories with his media colleagues while he was running a successful hedge fund. Through manipulating the media, Cramer was able to move stocks in the direction he wanted in order to cash in. In a startling kiss-and-tell online interview he admits that the hedge fund game consists of one lie after the other. Furthermore, he says that if you're not willing to lie, cheat and violate the law, "maybe you shouldn't be in the game."  

  • To provide even more incentive for hedge fund managers to cheat their way to riches, the federal tax code rewards them with a special tax loophole called "carried interest." As a result, billionaire hedge fund managers pay a lower tax rate than the rest of us, and neither political party has the nerve to remedy this blatant injustice.

Let us now praise famous hedge funds?  

Because so few of us know these stories, and because so few of us feel comfortable wading into the muck of high finance, hedge fund moguls preen about the universe bestowing a small part of their ill-gotten gains upon institutions that can help them enhance their reputations. Central Park and the New York Public Library are receiving $100 million each from prominent hedge fund managers seeking to polish their images. Colleges want hedge fund managers on their boards and in charge of their endowments. Non-profits, even progressive ones, kiss up to them, hoping to score big donations. Pension funds scramble to invest in hedge funds, looking to secure a share of the booty.  

But very few have the nerve to ask where hedge fund riches really come from. If you're receiving such largess, you don't want to know if the money is tainted. Better to pretend that these guys are just brilliant investors with the uncanny gift for making 30 percent a year, year after year after year.  

All of us should be grateful that our Wall Street-riddled government still has honest prosecutors like Preet Bharara who are not afraid to ferret out the cheats and put them away. So far his Manhattan office has secured 81 indictments against hedge fund managers and traders, 74 of whom have either have pled guilty or have been convicted.

Only another 10,000 or so to go.

Les Leopold is the director of the Labor Institute. His most recent book is "How to Make a Million Dollars an Hour: Why Hedge Funds Get Away with Siphoning of America's Wealth (Wiley, 2013)." His next book project will focus on why the richest country on earth is so poor.

 
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