Outstanding Performance by Breaking the Rules
Two recent items serve as reminders about how hard it is to generate great investment performance, and how difficult it is to spot those who have decided to cheat. In a few days, Anthony Chiasson and Todd Newman will face trial on charges of insider trading. Mr. Chiasson is the founder of Level Global Investors, and Mr. Newman was a portfolio manager at Diamondback Capital Management. They are alleged to have generated $68 million in illegal profits by trading on inside information in technology stocks through their respective hedge funds.
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On Sunday, Aletheia Research and Management filed for bankruptcy amid an SEC investigation into illegal trading practices. The firm is owned and managed by Peter J. Eichler, Jr., and at one point managed about $9 billion. Bankruptcies are rare among management firms. It takes a great deal of effort to lose enough clients and run up enough debt to necessitate the protection of bankruptcy. Mr. Eichler has managed to do it by spending lavishly on his firm and himself, while getting into a row with his former partners and running afoul of the SEC.
These two cases demonstrate a couple of key points about money management. First, pay attention to the investment process and don’t get caught up in the personal lives of the principals. Second, rather than worshipping those who generate outstanding performance, subject them to intense scrutiny. Third, even if you’re willing to dig deeply, cheating is hard to detect.
With hindsight, Mr. Eichler’s lifestyle seems like a dead give away that something was wrong at Aletheia. According to a lawsuit filed by a former partner, Mr. Eichler spent millions in office renovations, took hugely expensive trips, and richly rewarded his friends and himself. Lots of money managers live large, accumulating houses, fine art, and other toys. However, their lifestyles aren’t an indicator of investment wrongdoing. By contrast, Messrs. Chiasson and Newman are said to live low-key lives.
Producing outsized returns, which Chiasson, Newman, and Eichler all achieved, is extraordinarily difficult to do. We tend to put these folks on a pedestal and laud their Midas touch. As investors, we should actually be asking a lot of questions of the overachievers. In most cases, great performance is actually pure luck, and in a few instances it is one of many types of cheating. Sustained and legitimate outstanding performance is rare and unavailable to the general investing public.
In this post, we’re looking at two ways to cheat. Messrs. Chiasson and Newman appear to have traded on non-public inside information unearthed by their analysts, who, in turn, were working together. Under U.S. securities laws, no one is supposed to invest on this type of information until it has been properly disseminated to the public. If a manager is able to get advance notice of earnings reports, product announcement, mergers or other price-moving events, he’s going to have a massive advantage over ordinary investors. The defendants claim that they did not know that their analysts were feeding them recommendations based on improper information. It’s very tempting to trade on “inside” information, as it is a sure-fire way of making money and embellishing one’s investment track record.
Mr. Eichler is alleged to have engaged in something called “late day trade allocations.” This practice involves removing unfavorable investments from a client’s account and placing them in the firm’s error account at the end of the trading day. All firms maintain an error account to absorb legitimate trading errors (e.g. buying the wrong security, or buying when you meant to sell). In this case, it appears that Eichler was trying to protect his investment record and his business by removing the bad investments from some client accounts. Late day trade allocations can also be used to favor certain clients by giving them favorable investments. The SEC is investigating Aletheia, and I expect they will unearth additional improper practices, as the firm was rife with accounting and reporting irregularities.
All of the people involved in these alleged transgressions attracted a blue chip list of clients. “Great” investment performance is a powerful lure, and a well-constructed illegal scheme is hard to detect.