In a recent survey of hedge fund professionals, nearly half (46%) believed that their competitors have engaged in illegal activity, more than one third (35%) have personally felt pressure to break the rules, and about one third (30%) have witnessed misconduct in the workplace. Amazing results, which speak to the challenge of seeking absolute returns.
The survey was conducted in February and March 2013 as a confidential online survey of 127 respondents who work in the hedge fund industry. The sample for the study came from three sources: HedgeWorld, The Hedge Fund Association and ResearchNow. It was commissioned by law firm Labaton Sucharow LLP, HedgeWorld and the Hedge Fund Association.
Do the survey results imply that insider trading is still occurring despite high profile prosecutions? 46% of respondents reported that their competitors likely have engaged in unethical or illegal activity in order to be successful. Note the past perfect wording doesn’t necessarily imply present infractions. Competitors could have engaged in unethical or illegal activity in the past, full stop. Competitors could have engaged in the past and still continue. The wording is ambiguous, and the addition of “likely” adds a bit more uncertainty.
What is not ambiguous is the perception of management. Nearly one third (28%) of respondents reported that if leaders of their firm learned that a top performer had engaged in insider trading, they would be unlikely to report the misconduct to law enforcement or regulatory authorities. It would be interesting to know what percentage of respondents worked at firms registered with the SEC. Unregistered firms would perhaps not feel the same obligation to escalate issues. More damning is that 13% of respondents reported that leaders of their firm would likely ignore the problem. That seems like a very high percentage given what has happened to Anthony Chiasson, Doug Whitman, Samir Barai, and Raj Rajaratnam. And looks like it is happening to Steve Cohen.
54% of respondents reported that the SEC is ineffective in detecting, investigating and prosecuting securities violations. Do respondents feel the same way about the FBI and Preet Bharara? The survey doesn’t tell us.
Most tellingly, 35% of respondents reported feeling pressured by their compensation or bonus plan to violate the law or engage in unethical conduct, while 25% of respondents reported other pressures that might lead to unethical or illegal conduct. And 13% of respondents reported that they may need to engage in unethical or illegal activity in order to be successful and an equal percentage would commit a crime—insider trading—if they could make a guaranteed $10 million and get away with it.
This gets us to the nub of the issue. Material non-public information is, by definition, pure alpha. If your job is to deliver alpha, MNPI is sitting out there beckoning like some unattainable paradise. Incentives to deliver alpha can seem to some like incentives to get insider information.
Even if you are a highly ethical hedge fund analyst who wishes to avoid any chance of a perp walk in front of family and friends, obtaining alpha has gotten harder and more confusing. In the past, the ethical analyst could work a little harder than his rivals by speaking to suppliers, key customers, and other corporate outsiders. The ethical analyst could collect bits of information about supply and demand, each bit being non-material in itself. “We just received a larger than usual request for our supplies to the product.” “We’ve doubled our orders, the product is flying off the shelves.”
Taken by themselves, no bit of information would move the stock if issued as a press release. But the ethical analyst could put these bits together into a mosaic which would be material and non-public, generating alpha. As we have noted before, mosaic theory is a much less certain safe harbor than it was. At the very least, analysts now have to worry about the confidentiality of non-public information, even if the information is not material. Prosecutors have shown that it is relatively easy to get convictions based on violations of confidentiality without sweating materiality.
So it is understandable if hedge fund professionals feel a bit disoriented. They are hired to deliver alpha. The sweetest, purest alpha is off limits but enticing to those with lower ethical standards. And even for those with high ethical standards, getting alpha has gotten more complicated.
If nothing else, the survey tells us that insider trading is not an issue that will be going away anytime soon.