Will looking at hedge fund outperformance help the Securities and Exchange Commission uncover more crooks—or merely be a wild goose chase?
At a congressional hearing in March, SEC enforcement director Robert Khuzami said the agency will focus on funds that regularly and steadily beat market indices by 3%.
Whether the SEC finds too many, or too few, funds that meet that criteria depends on whether it looks at monthly or annualized performance.
In an AR analysis of U.S. long/short equity funds reporting to the AR database, about 76% of U.S. long/short equity hedge funds outperformed the S&P 500 by three percentage points or more on an annualized basis over a five-year period ending December 2010.
But when looking at monthly returns, only about 4% of those funds outperformed consistently—defined as greater than 50% of the time—over the period.
If the SEC went after funds based on annualized returns there would be too many funds to investigate, which makes the errand seem foolish. Looking at monthly performance narrows the field more.
Some industry analysts think outperformance is not really the issue, if the SEC is looking for Madoff-like crimes.
To catch that, the SEC should focus on funds that generate positive performance that consistently falls within a few basis points, they say.
“Madoff was up the same percentage points like clockwork every month,” said one hedge fund lawyer.
“It would be more useful to look at hedge funds whose positive performance falls within a narrow range, such as three or four percentage points every month,” he added.
The monthly overperformance metric might have trapped Galleon Group, however. Galleon founder Raj Rajaratnam was convicted in May on 14 counts of conspiracy and fraud.
According to the AR database, four of Galleon’s biggest funds beat the S&P 500 by three percentage points on a monthly basis 58% to 62% of the time from the beginning of 2007 through the end of 2008—the time period the insider trading took place.
