What Investors Can Learn From The Fall of Raj Rajaratnam

A closer look at key takeaways for investors.

By + More

SmarterInvestor_Beck2.jpg
Steve Beck
Raj Rajaratnam, founder of the Galleon Group Hedge Fund, was found guilty this past Wednesday in what has become the new high-water mark for insider trading convictions.

Using techniques once reserved for organized crime, drug trafficking, and terror plots, the Justice Department was able to convict Rajaratnam on 19 counts of security-related fraud. His conviction involved a complex web of more than 23 known parties ranging from corporate executives to hedge fund managers, and reveals just how deep insider culture runs among the Wall Street elite.

[In Pictures: 6 Numbers Every Investor Should Follow.]

With the spotlight temporarily on this aspect of the hedge fund world, it behooves us to pause and underscore a few key lessons for everyday investors:

The little guy can't win. Every now and again you run into that day trader or active investor who has discovered the "golden cross" of technical analysis, or has gained some yet-to-be perceived insight into the global economy that he is poised to exploit.

Forget the fact that thousands of financial researchers churned out of the top Ivy League schools are employed by leading hedge funds, equipped with staggering research budgets, sophisticated analysis technologies, and shocking financial rewards for success. Forget that these researchers are probably a bit smarter than you. Forget that they crunch data like robots, day after day, looking for any edge. Forget that even if the playing field were level, you would have to be a bit deluded to want to compete against such a formidable opponent. Then add to these facts the reality illustrated by Rajaratnam's conviction: These organizations sometimes get trading information first—illegally. The answer becomes simple: The little guy cannot win.

[See How to Retire on Social Security Alone.]

For the individual investor, active stock trading is nothing short of Popeye fighting Bluto with no spinach in sight. Such a contest is so one-sided that it goes from being entertaining, past pathetic, to downright disgusting. As the Las Vegas adage goes, "Look around the poker table and if can't spot the sucker, it's you."

Fees really do matter. What do 2 and 20 mean to you? Probably not much unless you've read the prospectus for a hedge fund. The going rate for playing in the hedge fund game is a 2 percent annual management fee on assets under management, and then a 20 percent profit share on all earnings. This is the fee burden the hedge fund manager must overcome to return value to the investor group.

With such a heavy fee burden, how do long-short equity hedge fund managers return value? They does so by building teams that perform deep research, astute analysis, and rapid response systems to exploit the smallest window of opportunity. And sometimes they succeed, as Rajaratnam has shown us, through insider information. Surprisingly, even with all these resources and advantages, over time many hedge funds fail to even beat the market. Two and 20 is a lot to overcome.

[See Time Running Out for Medicare Fix.]

Some things never change. The Galleon verdict is an encouraging example of justice, but just how deep is the insider problem? According to the Cayman Islands Monetary Authority, there are more than 5,000 hedge funds representing over $2.3 trillion in investments. And although many of these funds conduct ethical enterprises, the dollars at play provide a substantial motive for misbehavior. Galleon is just the tip of the iceberg.

When malfeasance turns up, however, investors are frustrated by the fact that many cases are lost in court or end with nothing more than a wrist-slap. The not-guilty verdicts for Bear Stearns hedge-fund managers accused of misleading clients, Angelo Mozilo's multi-million settlement to erase fraud charges with the Securities and Exchange Commission, and the lack of indictments against Wall Street executives for misdeeds in the financial crisis are all examples of injustice winning the day. One commentator likened these efforts to a fruitless and frenetic game of whack-a-mole. You may strike a mole here and there, but a lot more disappear into their hole to never face any consequences for their action.

[See 401(k) Savings Inches Upward.]

The individual investor, however, need not despair. Through simple indexing and global diversification, you can tap into the value of corporate productivity and global economic growth, and side step the rigged world of active trading. Add to this the discipline of vigilantly driving down all unnecessary fees within your portfolio, and in the end, you may in fact have the last laugh.

Steve Beck is cofounder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater peace of mind knowing that they are leveraging the best thinking of Nobel laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.