Two major events took place this past week in the financial world. First, news came out that finance is about to become the largest industry in the S&P 500 again. The last time that happened was May of 2008. We all know how that movie ended. Second, government regulators actually managed to, get this, regulate someone on Wall Street. They indicted the massive $14 billion SAC Capital hedge fund for insider trading “on a scale without known precedent.”
On the surface, these two news items seem unrelated. But, to my mind, they’re intrinsically linked–and not in a good way.
Taken on its own, you might think that an (allegedly) crooked hedge fund getting busted is the signal of better days to come on Wall Street, with more responsible money managers and more robust oversight. But with financial companies making up such a massive portion of our economic growth–without banks, the S&P’s profits would actually be down this quarter–I am not at all optimistic that the SAC indictment will lead to anything like the reform we need. Sure, the widely publicized case might hammer the hedge fund industry, which has already been taking plenty of lumps lately for underperformance. But it’s not going to get at the core problem that led to SAC’s downfall:
Wall Street has been living through its own steroids era. And both the SAC case and the resurgence of Big Finance show that it’s not even close to being over.
A few years ago, a wire thin baseball player by the name of Barry Bonds suddenly started to look like a cross between Robocop and a Russian weightlifter. His hat and shoe sizes grew almost as fast as his home run totals. Around this same time, another famous athlete named Lance Armstrong not only recovered from cancer, he went on to win a record number of bicycle races. In retrospect, it should have been obvious that both men were enhancing their performances somehow, but people were too busy cheering their successes to do anything about it.
While Bonds was smashing home runs and Armstrong was donning yellow jerseys on the Champs-Elysees, investment banks were pumping up their portfolios with enormously lucrative designer investments like subprime mortgage bonds. Eventually, Bonds and Armstrong were exposed for the frauds they were. So was Wall Street. But a half decade after the financial crisis, there are still tons of athletes and Wall Street wheels out there today making fortunes by (allegedly) breaking the rules.
Don’t get me wrong, I’m not saying SAC’s founder Steven Cohen is some kind of financial “Sith Lord,” like Overstock.com’s rather unhinged CEO Patrick Byrne did in a full page ad this past weekend, but Cohen’s record is eerily Bonds and Armstrong-like. Over two decades, he’s averaged 25 percent returns. Those numbers are staggering, especially given the size of SAC’s assets under management. If you’ve sucked in billions in AUM, as Cohen has, it’s almost impossible to outperform the indexes by such a massive degree without engaging in one or more of three very risky methods: leveraging up, investing in high beta stocks, or out-and-out cheating. The SEC says that Cohen did a lot of the third, and they’ve got some pretty damning evidence to prove it.
But, as with Bonds in baseball and Armstrong in bike racing, Cohen is far from alone in posting (allegedly) too-good-to-be-true returns. There are countless other bloated, multi-billion dollar funds out there doing the same thing. Unfortunately, as the investigation of Cohen’s (alleged) misdeeds has proceeded, the commentary in the business media hasn’t been focusing on that fact, but rather which of those enormous funds will poach SAC’s investors. That’s why the first news item from the past week is so significant, and dispiriting. As Big Finance continues to inflate to pre-2008 levels, there’s only going to be more incentive for fund managers to engage in (allegedly) Cohen-like behavior.