Saturday, November 24, 2012

The Temptation of Insider Trading

The Temptation of Insider Trading

Publicly traded financial markets cannot be beaten over the long haul.  By the time fees are factored into the equation, investment returns will fall short of a well-constructed benchmark.  While I don’t believe that markets are entirely efficient, money managers make enough mistakes in buying and selling securities that the occasional inefficiencies are swamped by errors.  Fortunately for money managers, millions of investors are willing to let them play this game despite the overwhelming evidence of their ineptitude.

Trouble Brewing (1999)
Because successful investing is so difficult, money managers are always looking for an edge.  Traditional managers dig for tidbits of information that aren’t reflected by stock prices.  Quants search for a mathematical formula (algorithm) or model that will spit out winning securities. Just about the time the manager becomes confident of his “edge,” it evaporates.

For the vast majority of money managers, their careers are marked by an honest, if futile, quest for the “edge.”  They legitimately dig through public information to try to find some angle that isn’t reflected in the price of stocks.  Lurking beneath this mass of public information is material inside information: the stuff that will move a company’s stock price but has yet to be released by a company. 

Inside information might consist of any number of items, such as a company’s quarterly earnings results, a blockbuster product release, the results of a clinical trial for a new drug, or a pending merger announcement.  You’ve undoubtedly experienced utter dismay when one of your stock holdings dropped 5% after a gloomy earnings report.  Now imagine you had a source deep inside a company who could tip you off before the earnings report.  If you knew the bad information in advance, you could sell your position and avoid the loss, or better yet, short the stock and earn a profit.  This is a place you cannot go as an investor.  If you knowingly act upon this information, you’ve violated the securities law.

Say you’re a big-time hedge fund manager who conducts in-depth research.  Given your 2% management fee, you can afford to hire a large number of portfolio managers, analysts, and industry consultants, and pay them a lot of money.  You expect this team to produce moneymaking ideas.  If they can’t deliver value-added insights, they’re going to be looking for a job someplace else.  There’s plenty for these folks to do in searching for investment insight: attending industry tradeshows, monitoring regulatory proceedings, checking company supply channels, or contacting a company’s customers.  All of this is fair game.  However, many other hedge funds, as well as mutual funds, are sifting through the same tidbits of information.  As a result, these insights are probably already reflected in a company’s stock price. 

So the portfolio manager, analyst, or consultant might be tempted to dig even deeper and begin to hunt for inside information.  After all, acting on inside information is a sure-fire way to make money: you’ve staked out a position before the market can possibly reflect the value of the information.  In the blizzard of stock trades, who will be able to discern a little bit of insider trading?  This brings us to SAC Capital, one of the most visible and successful hedge funds.  In recent days, the Department of Justice has filed a criminal complaint against a former portfolio manager of SAC Capital, Mathew Martoma.  Mr. Martoma is alleged to have sold positions in two pharmaceutical companies, Elan and Wyeth, after learning from a consultant that a clinical trial had failed.  The consultant not only worked for SAC, he was responsible for monitoring the clinical trial for the two drug companies.  The Justice Department alleges that Mr. Martoma not only avoided taking a loss by selling both stocks, he shorted the stocks and made a profit when the bad news hit the market.  Between the avoided loss and the profit on the shorts, SAC is supposed to have earned about $270 million.

The government has to show that Mr. Martoma knowingly traded on the inside information.  The key component of the government’s case will be the testimony of the consultant, Dr. Sidney Gilman, who was granted immunity in exchange for his cooperation. 

This case is one of a series of proceedings against SAC employees.  Thus, the big question is whether the government will eventually indict Stephen A. Cohen, the founder of SAC.  Mr. Cohen has generated an enviable investment track record and is known for taking very aggressive positions in stocks.  According to government records, Mr. Cohen discussed the sale of Elan and Wyeth before the trades were executed.  However, we don’t know whether they discussed Dr. Gilman’s inside information.  The answer to that question may depend on Mr. Martoma’s willingness to cooperate with the government.

As investors, we’re left to wonder if SAC Capital’s track record is too good to be true.  Even if it isn’t, the government may not be able to prove its case.

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