Asset Manager

If doubling the tax rate for carried interest was a blow to private equity funds, now it is hedge funds turn with the FSA announcing that it is launching a formal ‘assessment’ (code for ‘investigation’) into the system hedge fund managers have in place to guard against market abuse. This after an initial review showed that some managers don’t have adequate controls.

This review lead the FSA to be ‘disappointed’ with some companies internal controls and said that market abuse training, in some cases, was ‘non-existent’. This review took in smaller firms and larger firms alike and is has prompted a wider initiative by the FSA to ensure good practices are developed within hedge fund management companies.

“We will be following up with the firms visited and are also launching a program of visits to a wider cross section of (hedge fund managers) over the coming months to formally assess their market abuse systems and controls,” the FSA wrote in its markets division’s monthly newsletter.

The FSA has wide reaching powers which can included sanctions on firms, expulsion or even legal action.

The review comes after the FSA found that nearly one-quarter of U.K. takeover deals were preceded by possible insider trading in 2005, the most-recent period studied, though there is little to suggest that hedge fund managers are more likely to engage in insider trading than any other market participant.

“Some (hedge fund managers) had a high level of awareness and appropriate controls in place, whilst others were less aware, had fewer controls and demonstrated a complacent attitude to the risks,” the FSA said.

This latest initiative by the FSA is due to a growing belief by regulators that insider trading is rife in the markets present both in the UK and US.

In March, the SEC caught a 14-person insider-trading ring that netted more than $15 million in profits and included a UBS research executive, a Morgan Stanley compliance lawyer, a Bear Stearns stockbroker, three hedge funds and a day-trading firm. In May, the SEC froze brokerage accounts owned by a Hong Kong couple it accused of turning an $8 million profit on Dow Jones & Co. shares after allegedly receiving insider information on News Corp.’s $5 billion offer for the group.

To catch rogue traders, regulators and banks increasingly are employing technology, such as complex event processing (CEP) and remote-control software, to monitor insider trading.

Investment banker Hafiz Naseem’s last move before boarding a plane from Pakistan back to his Madison Square Park office in New York was to take out his Blackberry and, just like millions of users worldwide, add a telephone number to his contact list. What Naseem didn’t know was that the move, like every single keystroke on his mobile device and laptop, was being monitored and logged in real time by an FBI agent back in the U.S.

When the 37-year-old banker landed in New York, he was arrested on insider trading charges in what proved to be the culmination of four months of investigation harnessing both traditional methods and new technology.

We have said it before on this blog, the regulators are getting tough and are probably being backed by a political will to catch the big guys. Someone’s scalp will be on the mantle of an ambitious politician soon, we are sure of it.

What of the algorithmic traders? Although a technological Bermuda Triangle myself, others in the industry are not so unskilled. Looking at charts and market movements in securities with the benefit of hindsight, it is fairly easy to spot inside trading patterns, but what of those computer trading programs that search out these anomalies and benefit from that trading pattern. In other words computer programs that are specifically geared to spot insider action and trade on it? Is that market abuse?

I understand that it is. Spies on your Blackberry, keystroke finders on your laptop and computer systems seeking out computers systems… It is all getting a bit 1984 for me.. and I don’t mean the dodgy hair do’s and the fluorescent socks, more an Orwellian nightmare.

When I traded commodities an old boss used to harp on about how volatility is ‘our friend’ and flat markets ‘the enemy’. He also said that in volatile markets ‘don’t cry for the losers, short them’.This has been good advice and in the last few months, some of the losers are big names in the industry but they have been royally battered by others. One of those doing the battering is Michael Burry, head of the $621mn fund Scion Capital, he has informed investors that their massive short of the subprime market is being unwound after generating a four-fold return.

“The opportunity in 2005 and 2006 to short subprime mortgages was an historic one,” Burry wrote in a letter to investors. “With continued hard work and a bit of luck, we will latch onto another opportunity like the subprime short. But I am not counting on it happening anytime soon.”

Scion Capital held $1.7 billion worth of short positions on parts of subprime mortgage securities, but by mid-October, those short positions had been whittled down to $479 million, according to a letter that Burry sent to investors this month.

Having being unwinding the positions from July through October the bet has so far generated four times the original value of the trade giving investors between 78% and 85% gains in the first nine months of the year.

Since their inception in late 2000, the funds have surged more than 300%. During that time, the Standard & Poor’s 500 Index gained less than 10%.

Scion’s Burry said in his October letter that it was time to “reset expectations,” noting that the firm’s returns have been “clearly outsized and far from normal.”

“Twenty percent annual returns are my rough goal, and I feel that is a properly lofty goal,” he wrote. “That is, it is not so high as to encourage excessive risk-taking.”
Some of that caution may reflect lessons Burry learned in 2006.

That year, Scion’s global strategy funds, the firm’s main investment portfolio, lost more than 16%. Burry had placed an early bet that the credit markets would deteriorate, but his strategy was too early in the view of some of his investors, and he was forced to withdraw their money well before the subprime debacle took shape.

“The pain was certainly intolerable for some of our investors, and some that were very close to me capitulated at the very bottom,” Burry recalled.

I suspect those that stayed in have forgiven Mr Burry and put him firmly back on thier Christmas card list…