Ongoing reports of scandal in the hedge fund industry, like The Wall Street Journal's report Monday that a trader at well-known firm SAC Capital may have traded on inside tips, are giving investors "general fatigue," says senior analyst Denise Valentine of Aite Group LLC. And this wearing out, she adds, could be a blow just as things are beginning to look up. According to Hedge Fund Research, in the third quarter, hedge funds saw their first period of net inflows for five quarters, with $1.1 billion in net new capital pouring into the space.
But with headlines being continually dominated by fraud, investors on the fence can easily sway them to hold off on new commitments, Valentine says. Indeed, the so-called headline risk associated with hedge fund investing is the number one concern among institutional investors, according to a 2008 study conducted by SEI Investment Co. (NASDAQ:SEIC), an asset management firm. In fact, this concern trumps even transparency and performance, giving Valentine's theory merit.
Whether these cases will have a material impact on hedge fund net inflows remains to be seen -- and whether the impact is quantifiable is still another question.
In addition, the different types of frauds might elicit different reactions from investors. For example, following the Madoff scandal, plan sponsors and consultants alike stepped up their due diligence: They beefed up their staffs and in some cases tapped outside consultants.
But what actions can an investor take to avoid getting caught up in a hedge fund that participates in insider trading? Are they supposed to be alarmed when one of their investments does especially well?
It has taken the SEC years of wire tapping, watching and witness-building to gather enough evidence to file charges against Galleon Group. Institutional investors can hardly be blamed for not catching on, nor is it easy to pinpoint something they can do to prevent the same situation from occurring in the future.
Besides depending on regulators to monitor and catch fraudulent practices, such as insider trading, investors can look for firms that have strong processes in place that prevent any one trader from having too much access, Valentine recommends. However, when insider trading is institutionalized at a fund, as it allegedly was at Galleon, it seems there is little investors can do but keep their fingers crossed. - Sara Behunek
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