Edged with colour

Date: Monday, November 2, 2009
Author: Richard Beales, Business Standard

Edge for hedgies: You can’t take the edge out of hedge funds. Along with other investors, most of them are looking for that extra insight. There’s no excuse for illegally trading on inside information, as Galleon Group founder Raj Rajaratnam is alleged to have done. That aside, getting an edge is their job – and their clients check up on them the same way.

Years ago when insider trading laws didn’t exist or were scarcely enforced, the whole point of trading in many markets was to profit from inside information. It’s a different story these days. Anyone even vaguely involved in financial markets should know when the legal line has been crossed. Some of the people in Rajaratnam’s network of contacts appear to have had sufficient misgivings to suggest they knew they were crossing it.

But investors – from managers of multi-billion dollar hedge funds to day traders – still buy or sell in the belief they know something most others don’t. Their edge could be as simple as a (legal) tip from a friend, as complex as the results of a clever financial analysis, or as time-consuming as the distilled conclusions of hundreds of phone calls to a company’s customers. Harnessing such knowledge successfully begets alpha – the ability to beat broad market returns. Investors also crave market colour. Just as a home-buyer might ask around to get a sense of what homes are available and may come onto the market, what discounts other buyers are offering to asking prices and so on, the idea is to understand market conditions and adjust trading and timing accordingly.

Arguably big investment banks like Goldman Sachs know far more about what investors across a range of markets are up to than any hedge fund can know or any investment bank trader will tell them. But for sure Galleon and many others, whether hedgies or more traditional asset managers, work the phones – and expect traders they transact with to offer up market colour in return for their business.

The tables can be turned, too. A JPMorgan asset management analyst raised concerns about Rajaratnam’s business practices back in 2001, according to the Financial Times. A former associate of the Galleon founder had given the analyst a “great deal of colour” about Rajaratnam’s style. Most people would encourage that kind of due diligence – which is really just another example of an investor legally looking for an edge.