Risking Jail in the Pursuit of Alpha

US News

Since April is financial literacy month, I thought it would be timely to give you a short quiz to test your financial IQ.

In which industries do almost half of the employees believe their competitors engage in illegal activity, more than a third feel pressure to "break the rules" and almost a third have been a witness to illegal conduct? Is the correct answer:

a) Members of Congress

b) Used car salesmen

c) Private detectives

d) Labor union leaders

e) None of the above

Congratulations to all those who selected "e." It's none of the above. This distinction goes to hedge fund professionals. It is based on an independent survey commissioned by a law firm, Labaton Sucharow, HedgeWord and the Hedge Fund Association.

What is it that motivates these well-educated, highly-paid employees to risk jail by engaging in illegal activity? The pursuit of alpha. "Alpha" is a measure of performance on a risk-adjusted basis. A mutual fund that has the same risk as the S&P 500 index and uses that index as its benchmark achieves alpha if it exceeds the returns of that index. Alpha is the holy grail for mutual funds and hedge funds. Fund managers understand that investors can capture benchmark returns (net of low management fees) simply by buying an index fund. To attract assets to their funds, they need to demonstrate the ability to capture alpha.

The motivation to achieve alpha is greater in hedge funds than in typical mutual funds. The management fee for mutual funds averages around 1.5 percent. Hedge funds typically charge 2 percent of assets under management, plus 20 percent of the appreciation of the fund. When investors pay these exorbitant fees, you can be sure their expectations for alpha are heightened.

Unfortunately, returns in hedge funds on average have been dismal for the past decade, significantly underperforming their benchmarks. I discussed this poor performance and other problems with investing in hedge funds in this blog post.

While the survey of hedge fund employees is disturbing, the reality is worse. A number of hedge fund managers have been convicted of insider trading and are serving time in prison for their transgressions. Recently, the SEC has been focusing on the alleged insider trading activities of employees of SAC Capital Advisors, a high profile hedge fund owned by Steven Cohen. According to The New York Times, at least nine current or former employees of SAC have been accused of participating in insider trading schemes. On March 29, Michael Steinberg, a senior SAC portfolio manager, was charged with insider trading. The five count indictment charges him with generating $1.4 million in illegal profits (a round-up number for SAC, which manages $15 billion). He has pleaded not guilty and is awaiting trial.

One former analyst employed by SAC pleaded guilty to being part of an insider trading scheme involving two technology stocks. The others have denied the charges against them and are awaiting trial. Mr. Cohen has not been accused of any wrongdoing and has denied any impropriety. However, SAC recently agreed to pay the SEC $616 million to settle two civil insider trading cases, while expressly denying any wrongdoing.

Let me turn the tables and ask you a question I am unable to answer:

The hedge fund industry appears to lack ethical, moral or even legal standards of conduct. It charges its clients unconscionable fees, and delivers (on average) pathetic returns. Yet, the size of the global hedge fund industry is estimated to be a whopping $2.13 trillion, including investments by pension plans and endowments.

Why?

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.



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