Pas­sive in­vestors and in­sider traders

The Pak Banker - - OPINION - Matt Levine

THIS week S&P Dow Jones Indices re­leased its an­nual SPIVA score­card mea­sur­ing how mu­tual fund man­agers per­formed rel­a­tive to in­dexes. Last year, "66.11% of large-cap man­agers, 56.81% of mid-cap man­agers, and 72.2% of small-cap man­agers un­der­per­formed the S&P 500, the S&P Mid­Cap 400, and the S&P Small­Cap 600, re­spec­tively," and The fig­ures are equally un­fa­vor­able when viewed over longer-term in­vest­ment hori­zons. Over the five-year pe­riod, 84.15% of large-cap man­agers, 76.69% of mid-cap man­agers, and 90.13% of small-cap man­agers lagged their re­spec­tive bench­marks.

Mean­while a lot of hedge funds have had a ter­ri­ble start to 2016, though it doesn't seem to mat­ter that much: "I think they are get­ting the ben­e­fit of the doubt," Dean Backer, global head of sales and cap­i­tal in­tro­duc­tion at Gold­man Sachs, said of many of the big­gest hedge fund man­agers, ow­ing to their his­tor­i­cal per­for­mance. "I'm not sure peo­ple know - if they took money out of hedge funds- where they would put it," he added.

Yes where can you in­vest other than in hedge funds? On the other hand, here is James Led­bet­ter won­der­ing "whether, as pas­sive in­vest­ing grows, it is hav­ing harm­ful ef­fects on the econ­omy as a whole." The harm­ful ef­fects here are pretty ten­u­ous. Led­bet­ter wor­ries that "a mar­ket with more pas­sive in­vestors than ac­tive ones will con­tinue to push money into the largest firms, whether th­ese com­pa­nies are ac­tu­ally per­form­ing strongly or not"; Cullen Roche replies that "pas­sive in­dex­ers rely on ac­tive ar­bi­trageurs to set prices," and that in fact, "as in­dex­ing has grown, the num­ber of mem­bers leav­ing the in­dex has in­creased." One thing about in­dex funds is that they don't trade that much; even if most in­vestors are pas­sive, most trad­ing will nev­er­the­less be ac­tive, and will pre­sum­ably push prices in the di­rec­tion that the fun­da­men­tals de­mand. Else­where: "Equity funds draw in­vestors for first time in 2016." And "Meet Forcer­ank, the FanDuel for Stocks." I thought stocks were the FanDuel for stocks? David Ganek was the co-founder of a hedge fund, Level Global In­vestors, that was raided by the Fed­eral Bureau of In­ves­ti­ga­tion in 2010 as part of U.S. At­tor­ney Preet Bharara's crack­down on in­sider trad­ing. Ganek was never charged with in­sider trad­ing, but his co-founder An­thony Chiasson was; Chiasson was con­victed, and Level Global was fined by the Se­cu­ri­ties and Ex­change Com­mis­sion. And then Chiasson's con­vic­tion was over­turned, and Level Global got its money back: Bharara's ex­pan­sive the­ory of in­sider trad­ing li­a­bil­ity turned out to be all wrong.

This didn't do Level Global that much good, since the FBI raid and the at­ten­dant pub­lic­ity -- the U.S. At­tor­ney's of­fice tipped off the Wall Street Jour­nal about the raid so it could get some pic­tures -- is bad for busi­ness, and the fund shut down in 2011. So Ganek sued the FBI agents and pros­e­cu­tors in­volved, claim­ing that they'd vi­o­lated his civil rights, and yes­ter­day a judge let his case go for­ward. Ganek's ba­sic claim is that pros­e­cu­tors knew from the be­gin­ning that he­wasn't know­ingly in­sider trad­ing: Their main co­op­er­at­ing wit­ness, for­mer Level Global an­a­lyst Sam Adon­dakis, ad­mit­ted to trad­ing on in­side in­for­ma­tion from Dell, and told the FBI that he had in­formed other peo­ple at Level Global about the source of the in­for­ma­tion, but said that Ganek him­self never knew the in­for­ma­tion came from cor­po­rate in­sid­ers. But when pros­e­cu­tors asked for a search war­rant, they sub­mit­ted an af­fi­davit falsely claim­ing that Adon­dakis said that Ganek knew about the source of the in­side in­for­ma­tion.

That is bad! You are not sup­posed to lie to the court! I don't re­ally know what pros­e­cu­tors were think­ing there. But one pos­si­bil­ity is that, the way they thought about in­sider trad­ing, it didn't mat­ter. The Preet Bharara the­ory of in­sider trad­ing, circa 2010, was that if you ran a hedge fund and any in­side in­for­ma­tion made its way to you, then you were guilty of in­sider trad­ing, re­gard­less of what you knew about the source of that in­for­ma­tion. The mere qual­ity of the in­for­ma­tion might it­self be a tip-off that it was il­licit. We some­times talk around here about one of the cru­cial lessons of the last few years of fi­nan­cial scan­dals, which is: Don't put it in writ­ing. But tak­ing that over-lit­er­ally can also get you in trou­ble. Here is a strange lit­tle Se­cu­ri­ties and Ex­change Com­mis­sion en­force­ment ac­tion against the West­lands Wa­ter District for do­ing some ac­count­ing ma­nip­u­la­tions to meet the debt ser­vice cov­er­age ra­tio in its mu­nic­i­pal bonds with­out rais­ing rates on cus­tomers.

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