Rajaratnam Conviction Reminds Us of Investing Dangers

When Galleon Group founder Raj Rajaratnam's conviction was announced today, I quickly thought about all the dangers you face when you trust hedge funds with your investment dollars. RC Balaban, my co-author on my next book about investing mistakes, shared some of the lessons from this cautionary tale.

"The myth is larger than the reality."

When Rajaratnam said those words to one of the people providing him insider information, he was referring to the fact that he wasn't such a star hedge fund manager. In truth, it could be applied to a host of lessons we can learn from Rajaratnam's conviction on all 14 counts of securities fraud and conspiracy to commit securities fraud.

Until his arrest in October 2009, Rajaratnam's hedge fund Galleon Group was considered an exceptional performer, reportedly recording average returns of 21 percent per year for its largest fund. The firm eventually oversaw more than $7 billion in assets before withdrawals in 2008 reduced the assets to $3.7 billion at the time of Rajaratnam's arrest.

It's true that unlike Bernard Madoff and Allen Stanford, Rajaratnam wasn't running a Ponzi scheme. The money was there. The government put the figure at $63.8 million in illegal profits and avoided losses. However, like Madoff and Stanford, Rajaratnam operated behind a curtain.

Hedge funds aren't regulated in the same way as publicly traded mutual funds, which have a high degree of transparency. While we first discussed transparency among mutual funds two years ago, it seemed worthwhile to mention the differences again:

• Publicly held mutual funds are a highly regulated industry governed by the Securities and Exchange Commission. Hedge funds are basically unregulated.
• Mutual funds are required to have audited financial statements. The audits verify the financial statements of the mutual funds including correspondence with the custodians, brokers and transfer agent of the funds that confirms the securities held.
• Mutual funds don't act as custodian of the assets.
• Mutual funds don't perform the fund's accounting themselves.

Lies and More Lies With no one to hold hedge funds accountable, there are few ways for you to know if the hedge funds you're interested in are telling the truth. In fact, the recent study "Truth and Delegation" noted that "Many funds suffer from operational problems, ranging from limited disclosure on past legal or regulatory offenses and the failure to use a major auditing firm to the frequent use of internal pricing."

One of the most telling items from the paper involved disclosing past problems. Of the 444 due diligence reports studied:

• 6 percent saw managers disclose a past problem, but fail to disclose other legal or regulatory items that should have been mentioned.
• 9 percent saw managers disclose no problems, but further due diligence turned up problems that should have been mentioned.

One more point. As has been noted before, the reported returns of hedge funds as an asset class contain numerous biases, such as survivorship bias and backfill bias. Rajaratnam's case sheds light on another potential bias -- ill-gotten gains. It's certainly possible that his funds significantly benefited from insider trading and reported those enhanced returns to hedge fund databases, which would pump up the asset class's returns as a whole.

Eugene Fama one remarked about hedge funds that "If you want to invest in something where they steal your money and don't tell you what they're doing, be my guest." The dangers of investing in hedge funds are similar to those of other investments falling into the categories of 'exotic,' 'interesting' or 'too good to be true.' Even actively traded mutual funds can fall into this category, as many of them trade in such a way that you don't know how the fund is invested.

Remember, when returns seem too good to be true, risk is present. And it may not just be market risk. Rajarantam reminded us of that.

More on MoneyWatch:

How to Tell if Your Money Is Safe 5 Reasons You Should Avoid Hedge Funds Hedge Funds Keep Great Returns for Themselves Why Buying Money-Losing Investments Can Be a Good Strategy Municipal Bonds: Was Meredith Whitney Right?
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