Three Investment Lesson from the Fall of the Insider King

Raj Rajaratnam, founder of the Galleon Group Hedge Fund, was found guilty this past Wednesday in what has become the new high-water mark for insider trading convictions.

Lining his own pockets with over $63.8 million in illegal windfall from his insider scam, this once humble Sri Lankan son of a sewing machine company manager grew in physical, egotistical and financial stature. Through his swollen cheeks he crowed to friends about his $7 billion hedge fund empire, stating that Raj, which stands for “King” in Sri Lankan, makes him the “King of Kings”. How about the Insider King instead?

Indeed, Raj Rajaratnam, did gorge himself like a king, but on more than just Kobe beef. Using techniques once reserved form organized crime, drug trafficking and terror plots, the Justice Department was able to convict the Insider King of 19 accounts of security related fraud. And his conviction involved a complex web of over 23 known complicit parties ranging from corporate executives to hedge fund managers revealing just how deep this insider culture truly runs among the Wall Street elite.

With the spotlight temporarily on this aspect of the malevolent hedge fund underworld, it behooves us to pause and underscore a few key lessons for the everyday investors.

Lesson #1 – The Little Guy Can’t Win

Every now and again you run into that day trader or active investor who has discovered the “golden cross” of technical analysis or has gained some yet-to-be perceived insight into the global economy which he is poised to exploit.

Forget the fact that thousands of financial researchers churned out of the top ivy league schools are employed by leading hedge funds, equipped with staggering research budgets, sophisticated analysis technologies and shocking financial rewards for success. Forget that these researchers are probably a bit smarter than you. Forget that they crunch data like auto bots, day after day looking for any edge. Forget that even if the playing field were level, you would have to be a bit deluded to want to compete against such a formidable opponent. Then add to these facts the simple Insider King illustrated reality that these organizations sometimes get trading information first – illegally, and the answer becomes simple. The little guy cannot win.

For the individual investor, active stock trading is nothing short of Popeye fighting Bluto with no spinach in site. Such a contest is so one-sided that it goes from being entertaining, past pathetic to downright disgusting. As the Las Vegas adage goes, “look around the poker table and if can’t spot the sucker, it’s you.”

Lesson #2 – Fees Really Do Matter

What does 2 and 20 mean to you? Probably not much unless you have read the prospectus for a hedge fund. The going rate for playing in the hedge fund game is a 2% annual management fee on assets under management and then a 20% profit share on all earning. This is the fee burden the hedge fund manager must overcome to return value to the investor group.

With such a heavy fee burden, how then does long-short equity hedge fund manager return value? He does so through building teams that perform deep research, astute analysis, and rapid response systems which exploit the smallest window of opportunity. And sometimes he do so, as the Insider King has shown us, through insider information. Surprisingly, even with all these resources and advantages, many hedge funds over time fail to even beat the market. 2 and 20 is a lot to overcome.

Lesson #3 – Some Things Never Change

Yes, the Galleon verdict is an encouraging example of justice, but just how deep is the insider problem? According to the Cayman Islands Monetary Authority, there are over 5000 hedge funds representing over $2.3 trillion in investments. And although many of these funds conduct ethical enterprises, the dollars at play provide a substantial motive for misbehavior. Galleon is just the tip of the iceberg.

When malfeasance turns up, however, investors are frustrated by the fact that many cases are lost in court or end with nothing more than a wrist-slap. The not-guilty verdicts for Bear Stearns hedge-fund managers accused of misleading clients, Angelo Mozilo’s multi-million settlement to erase fraud charges with the Securities and Exchange Commission, and the lack of indictments against Wall Street executives for misdeeds in the financial crisis are all examples of injustice winning the day. One commentator likened these efforts to a fruitless and frenetic game of whack-a-mole. You may strike a mole here and there, but a lot more disappear into their hole to never face any consequence for their action.

Although we applaud the conviction of the Insider King, remember that when it comes to Wall Street, some things never change.

The individual investor, however, need not despair. Through simple indexing and global diversification, you can tap into the value of corporate productivity and global economic growth and thereby side step the rigged world of active trading. Add to this the discipline of vigilantly driving down all unnecessary fees within your portfolio, and in the end, you may in fact have the last laugh, even on the Insider King.