Scott Adams, “Dilbert” cartoon creator and social science blogger, uses a Lance Armstrong analogy to persuasively argue that many hedge funds probably engage in insider trading. Adams claims that cheating will likely occur when:
1. It’s easy.
2. The payoff is huge.
3. The odds of getting caught are low.
Until recently at least, these three conditions held in professional cycling because medically sophisticated teams could improve their performance with illicit doping while avoiding detection.
Let’s say that 90% of people are basically honest. Industries in which Adams’ three conditions apply are, however, likely to become dominated by the amoral 10%, as cheating would give them an almost insurmountable lead.
Insider trading can give hedge funds a relatively safe means of cheating. Let’s say you work at a hedge fund and have dinner with a former MBA classmate who works in management for a pharmaceutical company. You know that this manager has important, secret information about the success or failure of a new clinical trial for an Alzheimer’s drug. Getting this information would help your hedge fund capture hundreds of millions in profits. Do you feel out your dinner guest to see whether you can get the information by offering cash, sporting tickets or an extremely well-paid internship to the classmate’s daughter? Most people probably wouldn’t risk breaking the law, but those who did would, on average, outperform their more honest peers.
Many successful hedge funds stay within the law. Some undoubtedly use sophisticated computer programs to outperform the market, whereas others beat the market just by luck. But the gains from cheating are so potentially gigantic that I strongly suspect many hedge funds pad their bottom lines with insider trading.
People who invest in hedge funds, just looking for the highest possible returns, implicitly reward those who engage in insider trading. It was perfectly legal for advertisers to sponsor the top performing cycling team even if the advertisers suspected the best cyclists doped their way to victory. Similarly, investors in hedge funds can legally profit from insider trading if they put their money on the top performing funds even if the investors agree with Scott Adams that “the majority of hedge funds are criminal enterprises hiding behind ‘secret’ algorithms.”
Cheating, of course, has risks. Perhaps a week after you get the inside information from the former classmate, he ends up getting arrested for cocaine use and to escape jail time he basically sells you to the prosecutor. Still, given that the only possible way for someone to catch you would be if the police found out about the conversation, you are probably safe.