The Insider Trading Crackdown Is Working -- Here's How We Know

"Everybody is trading on the inside somehow or another," Rolling Stone reporter Matt Taibbi wrote three years ago. "A lot of sources I talked to suggested that this is endemic to the entire culture. The real issue here is it's everywhere ... And the fear is there's no end to it."

We will never get rid of insider trading, but there's a sign that the FBI's crackdown over the last four years is working.

Just look at hedge fund returns. 

Here are the average annual returns of equity long/short hedge funds -- those betting on the direction of stocks -- relative to the S&P 500 (SNPINDEX: ^GSPC  ) :

Source: Boomerang Capital, Standard & Poor's, author's calculations. 2013 returns through June, average of all hedge funds. 

Hmm.

The FBI insider trading crackdown began with the 2009 perp-walked arrest of billionaire Raj Rajaratnam and has led to more than 70 arrests, guilty pleas, and convictions. Hedge funds' performance relative to the broader market has been abysmal ever since.

We can't say for sure whether poor returns and criminal indictments are related. The hedge fund industry has gotten so enormous -- Barry Ritholtz notes that there are more hedge funds in America than Taco Bells -- that competition should limit returns. And money managers have severely underestimated the power of the economic recovery and market rebound.

But, come on. Look at that chart.

Hedge funds used to be able to earn big returns without pushing the limits of the law. They could, say, buy a basket of stocks trading below net working capital, short a basket of stocks trading well above their normal valuations, and expect to do well. It's different today. There's much more competition among those trying to exploit short-term market inefficiencies. Any "edge" you can maintain over the competition is stupendously valuable -- according to Forbes, there are more than 50 hedge fund and private equity billionaires. And as James Surowiecki points out, fewer companies are offering quarterly earnings guidance. That pushes the value of inside information up even more. It's one of the last remaining edges professional investors have.

We know insider trading occurred on a massive scale. According to a study by Measuredmarkets, 41% of U.S. companies receiving a buyout bid in 2006 had suspicious levels trading of activity just before the deals were announced. Another study by two NYU economists showed that the more bankers involved with a merger deal, the more likely suspicious trading is to occur just before the deal is announced. There's also evidence that suspicious trading has declined during the insider trading crackdown. Abnormal trading before buyouts of U.K. companies has fallen by half since 2009, according to the Financial Conduct Authority.

This is what was supposed to happen. It's well known that the IRS goes after celebrity tax evaders to make headlines and scare average folks into following the rules. Arresting Rajaratnam, and last week's criminal indictment of megahedge fund SAC Capital, does the same thing. In a January interview, Pulitzer Prize-winning journalist Ron Suskind told me:

You see, that's how you create a cultural moment. Because everyone left behind, they all say the same thing at the same moment. "Geez, if that happened to me, my mother would be so ashamed of me." That's how you do it. You do it by saying "Guess what? There are consequences here. I don't care how many lawyers you've hired. I don't care how much you're paying Sullivan & Cromwell [a large law firm]. You're going down."

It's working.

And that's good news for the rest of us. The problem with insider trading goes beyond fairness and creating a level playing field. It's about an industry that attracts the nation's best and brightest minds while not creating new wealth, but siphoning money off of existing wealth thanks to insider tips.

Sorry the game is up, all you brilliant hedge fund managers. But the rest of the economy needs your talents somewhere else.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 


Read/Post Comments (10) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 31, 2013, at 3:18 PM, cooncreekcrawler wrote:

    I sincerely hope you are correct.

  • Report this Comment On July 31, 2013, at 5:22 PM, Costanzawallet wrote:

    By the lack of oversight by the SEC I have a suspicious feeling that most working there are or have done their share of this type of trading and turn a blind eye for fear of exposing their own wrongdoing. We can only hope that somewhere there are some untouchables left, some with integrity and honesty, a rare thing to find these days.

  • Report this Comment On August 01, 2013, at 11:36 AM, bamasaba wrote:

    I appreciate your final observation. The fact that so many of our most well-trained and brightest young people have gone into banking and hedge-funding, as opposed to engineering, teaching, sciences, etc., is a national catastrophe.

  • Report this Comment On August 01, 2013, at 12:20 PM, Gowithit wrote:

    What a surprise, both parties stink but Democrats are slightly better at at least appearing to care that people are getting screwed. This is why so much corporate money went to Republicans in 2010 and 2012, the party is still going, just forcing people to be a little less obvious. Bush's admin oversight of the financial markets was the direct cause of 2007-2008, don't let anyone try to fool you with smokescreens to the contrary. It is a conscious choice we still have today, it's the less government, less regulation folks who just never wise up. And our next Republican administration will be just as bad if not worse. When business is allowed to run roughshod, they run roughshod, no surprise there. Government does the same thing, but at least we have some say there.

  • Report this Comment On August 01, 2013, at 6:33 PM, iamkilaru wrote:

    There was a professor ( I forgot his name) from Booth School of Management who used to argue that there is no need for a regulator and strong judiciary is sufficient.... I wonder what he says now...

  • Report this Comment On August 01, 2013, at 7:18 PM, cmalek wrote:

    Sure it's working. And suspending or banning a few baseball players for using performance enhancing drugs will eliminate their use. If you believe either one or both, I have a choice of bridges for you to buy.

    The only way to eliminate insider trading is to eliminate the stock market, and we know that will never happen.

  • Report this Comment On August 01, 2013, at 8:58 PM, SkepikI wrote:

    @Gowithit- hilarious. If you think one party rule is good for your pocket book (either party) I would like to make your acquaintance because I have either a great business deal OR a wonderful caring and "ethical" candidate who will represent the downtrodden to make a campaign contribution for....

    In my multi decade Dem dominated state, the corruption and cronyism is costing us a bundle (I could cite a dozen specifics that would bore you) and no its not Detroit, poster child for Dem dynastic rule.

    But of course ID of the con men and women would not be your strong suit. ID of the corporate crooks blinds you to the scam you are vulnerable to....

    There are MANY hedge fund cons but if you are a serious long term investor L-o-n-g Term Investor I mean.. the hedge funds will only serve your purposes as the motivators of BDM, Big Dumb Money. Case in Point, APPL, F, GLW... I wont go on.

  • Report this Comment On August 01, 2013, at 11:57 PM, colleran wrote:

    I don't see the chart

  • Report this Comment On August 02, 2013, at 12:08 AM, TomBooker wrote:

    Let me do the meme, since nobody has put it up as of yet.

    But first a wisecrack....

    All I have to go by in performance of Hedge Funds is those reported in the HSBC Weekly. I haven't wasted the wind on intense analysis, but both broadly and generally it has looked to me... in the past ~5 years, about 90% of those coughing up their 2 and 20 would have been better off with a big wad of SPY instead. ;)

    I'm not smart enough to know, but it appears "hedging" has not been maximally productive during our post-Disaster market march-up.

    Down to business of the obvious....

    As much as moonbats like my brethren and I, have screamed on the Admin and called for Eric Holder to be charged with treason for inaction on our fav "Banksters" and their alleged fraud....

    It never had to be a chain gang of Blankfein, Dimon, Mack, etc etc being marched to prison while the storm of multiple prosecutions shook the Financial System to the verge of rubble.

    It just had to be one solid prosecution which, like normal prosecutions do by nature, moved far enough up into the Executive Offices to send a necessary chilling effect, and visions of... negotiated sentences, .... bonus clawbacks... front page names and pictures....and a final icebreaking fear at 2:30AM bolt upright in bed, that YOU might somehow end up being the whipping boy for EVERYTHING which EVERYBODY did.

    I bet Ron Suskind is good company, and his quote certainly gets it right.

    BTW, his book saved me from the excessive mental distress, caused by that Sorkin thing.

  • Report this Comment On August 02, 2013, at 8:12 AM, gkirkmf wrote:

    I wonder how all the inside traders feel now that they know that the government has access to all their phone calls and internet activities... finally a "good" use for our NSA spy crew... Rooting out the white collar criminals in our financial system.

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