17 March 2013

John Gapper: Hedge funds' reputation in the balance

The regulatory squeeze on trading and risk-taking within banks through new regulations has pushed them further towards the financial fringe. This has advantages for the system as whole – hedge funds are not too big to fail, and many do. Taxpayers are not forced to underwrite the risks taken by traders at funds that make mistakes. Instead, hedge funds are genuinely entrepreneurial and self-supporting.

But they are also lightly regulated and charge their investors very high fees to participate. They must keep producing exceptional returns in order to remain in existence, which in turn puts portfolio managers under pressure to do whatever it takes to gain their “edge”.

In the emerging financial world, hedge funds are not only the most rewarding places to work, but are also Wall Street’s best customers. Equity funds such as SAC pay high commissions to investment banks to be first in line for information. They also pay other intermediaries – notably the “expert networks” now drawn into the insider trading investigation. These consultants charge funds to connect them with executives, who are supposed to provide insight into their industries. In practice, some seem to have provided more – inside information into product development... 

Is this kind of activity occurring within other hedge funds? Rather than being exceptionally skilled, are they instead high-octane and high-pressure operations in which some fund managers pay industry insiders for illicit information?

If so, the regulation of the past five years is having one extremely unintended consequence. It is pushing moneymaking from large, supervised institutions into a financial Wild West of dubious legality. Hedge funds need only look at banks – or Fleet Street – to witness the severe effects of an industry being discredited over the sins of some institutions. The same is in danger of happening to them.

© Financial Times