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Sebastian Mallaby on SAC Capital, insider-trading investigations and why hedge funds benefit society

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Sebastian Mallaby, a veteran of the Washington Post and The Economist, came out this summer with what has been described as the definitive study of the hedge-fund industry, carrying the evocative title “More Money Than God.” Using his unprecedented access to some of the most secretive and wealthy investors in the world, Mallaby explored the gilded world of these high-flying investors and explained why many hedge funds seemed to come out of the financial crisis better than the rest of the financial industry -- with a few big names like John Paulson raking in billions of dollars during the crisis.

More recently, hedge funds have been in the news for less brag-worthy offenses. Last week federal agents arrested a consultant to a number of hedge funds. It appears to be just the front edge of a massive new investigation of insider trading at hedge funds, this one focused on what have been called expert network consultants who connect fund managers with employees at companies they might invest in. Money & Company caught up with Mallaby to ask where the investigation came from and what it might mean for the future of this booming corner of the financial world. Here is an edited transcript:

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Money & Company: When your book came out did you have a premonition that anything like this investigation might be coming?

Sebastian Mallaby: It doesn’t surprise that from time to time when there is an insider-trading scandal hedge funds will be mixed up in it.

You start from the idea that these guys are the most aggressive investors seeking any kind of edge they can get any time. And then you’ve got an industry that uses expert network consultants that may be on the edge of legality.

It also doesn’t surprise me that after a big financial crisis the prosecutors have had to collect some scalps -- and they get more aggressive in the way they go after potential crooks.

M&C: How new are these expert networks?

SM: In the past, successful investors constructed their own expert networks.

Take the example of Julian Robertson, who ran the Tiger Fund between 1980 and 2000, the core of which was stock-picking. He had two Rolodexes almost the size of wagon wheels. Whenever he was advised to take a position in a stock, he could usually pull out of those Rolodexes three names of people who had worked for the company in question or been a senior executive at one of its suppliers, and he would call them up and have them debate his analyst.

He was a master networker.

The new thing may be that as the financial sector has grown and become more specialized, you have companies that style themselves as boutique expert network providers, whereas before this was folded into the larger houses, or the hedge funds would do it for themselves. But it’s always been the case on Wall Street that who you knew was the currency.

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M&C: A number of the people that they are tracking in this case have had some connection with one of the most famous hedge funds, SAC Capital, run by Steven Cohen. Can you give me some sense of why Cohen and his firm might be attracting the attention of the prosecutors?

SM: Steve Cohen has had among the highest returns in the industry.

Insiders in the business for a long time suspected that his special sources amounted to privileged information. The debate amongst insiders was, “Was the special information on the right side of legality or the wrong side?” But I think it was a pretty common view that it was close to the edge.

The returns were really very high and it wasn’t as though there appeared to be some sort of special source that you could easily understand. For example, Renaissance Technologies makes extremely high returns as well, but everybody understands that there is an algorithmic trading strategy that is simply the best ever invented. This guy Jim Simon brought together a team of outstanding mathematicians. They make extraordinary returns but we understand they are better at math than we are.

When you have somebody who doesn’t appear to have that readily identifiable edge, who nonetheless makes much higher returns than other people, you wonder.

Any curious prosecutor looking at white-collar financial crime would know that and would have SAC as something to keep an eye on.

M&C: You argue in your book that the benefits of hedge funds outweigh the risks. Why is that?

SM: Even though hedge funds get mixed up in financial scandals, there is no evidence that they are systematically more prone to breaking the law than other types of investment vehicles. You have to ask yourselves, aside from lawbreaking, are they good or are they bad. My argument is that they are less likely to misallocate capital than others because they have better incentives on the upside, because they get a profit share. They have the incentive to really do the research. On the downside, because the managers usually have their own savings on the line, they have a reason not to blow it up and to make moonshots like the proprietary traders at the banks did.

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Then in addition to that, they don’t get bailed out with taxpayer money. They are small enough to fail.

M&C: There is a widespread belief that hedge funds only get the big returns they do by using inside information that others are not privy to. What do you make of that?

SM: It might be a big part of why some funds get big returns.

I’m convinced, though, that this is not a good generalization as to why hedge funds generate excess returns. Stock-picking hedge funds are only one part of the hedge-fund universe. There are all sorts of other kinds of hedge funds that trade currency and debt, and those guys have no insider-trading laws and therefore can’t break them. And they also generate profits.

The reasons they make money is that markets are not perfectly efficient -- and hedge funds are just specialists who figure out what these distortions are and how you make money from them.

M&C: When they make billions, does it hurt ordinary investors?

SM: We should remember that the ordinary person is the end beneficiary of quite a lot of hedge-fund profits. Roughly half the assets are not provided by rich individuals -- they are provided by institutions like college endowments and pension funds. The profits are flowing through to the retirees who are ordinary working Americans.

In addition, when hedge funds make a profit they do that by taking an inefficient price and bidding it up or down. They make the price more fair, more accurate -- so that if I am a retired granddad and I need to sell my shares of IBM, I am getting a fair price for it. Also the transaction cost in selling it will be better because there will be more liquidity.

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M&C: When many people hear ‘hedge funds’ they think of big estates with helicopter pads owned by hedge-fund managers in Connecticut. How does the culture of extravagance factor into how you view this world?

SM: Before I wrote this book I had written a ton of economic journalism, including a series that was a Pulitzer finalist on income inequality. So I take inequality in the U.S. very seriously.

I believe that hedge-fund profits should be taxed a lot more than they are. I don’t like the helicopter pads.

The solution to humongous hedge-fund profits -- and the fact that in 2009 the top 25 hedge-fund guys made a total of $25 billion -- is to tax them. It’s not to close down their trading techniques, which are basically beneficial for society.

M&C: Are there any developing problems with hedge funds today that worry you for the future?

SM: The most troubling endemic problem at hedge funds is the tendency for the sector to concentrate. You are getting mega hedge funds. Out of this appealing entrepreneurial landscape there is going to arise these big mountains that follow the same trajectory that Goldman Sachs or Lehman Brothers did from the 1950s to the ‘90s -- when they began as small pools of private capital and morphed into big public companies that were systemically toxic.

That is what the hedge-fund sector is in danger of doing.

-- Nathaniel Popper

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