In this fourth installment of my Wall Street Profiles series, I profile Raj Rajaratnam, the billionaire hedge fund manager at Galleon Group who was sentenced to 11 years in prison for insider trading in 2011. It illustrates that the stock market is not always a level playing field, and trying to beat the market means competing against traders on Wall Street’s version of performance-enhancing drugs.
Until his dramatic fall in 2009, Raj Rajaratnam was an immigrant success story. His family moved from Sri Lanka to England when he was 14, and he got his MBA from Wharton in 1983. From there, he rapidly rose the finance ranks, with stops at Chase Manhattan Bank (now part of J.P. Morgan) and Needham & Co. In 1992, he formed his own hedge fund that would eventually become the Galleon Group.
Rajaratnam’s hedge fund was tremendously successful, never having a losing year until 2008. This 16-year streak of positive returns is quite remarkable, rivaling that of Bill Miller at Legg Mason Value Trust. His impressive returns in the 1990s are no surprise since he specialized in tech stocks. But he was profitable even when the tech bubble burst in 2000. The fund had returns of 26%, 8%, and 6% in 2000, 2001, and 2002, respectively. Like all profitable hedge funds, investors poured their money into Galleon Group, and Rajaratnam managed $7 billion dollars in 2008.
Insider Trading Charges
As beautifully profiled by George Packer in the New Yorker, Raj Rajaratnam built an impressive Rolodex of contacts both within Wall Street and in the tech industry. Using a combination of charm and offshore payments, Rajaratnam received insider trading tips from a wide network of individuals. Informants included Anil Kumar, a senior McKinsey consultant; Rajat Gupta, a former board member of Goldman Sachs; Rajiv Goel, an Intel executive; and Danielle Chiesi, a hedge fund manager who received insider tips of her own and passed them on to Rajaratnam.
Here are just a few of the many trades where Rajaratnam profited from insider trading:
- July 2008: An Akamai executive passed information to Danielle Chiesi, a hedge fund manager, that the company would miss earnings estimates. Chiesi then shared this inside information with Rajaratnam, and both shorted Akamai stock in advance of the earnings miss.
- October 2008: Rajat Gupta, a board member of Goldman Sachs, tipped off Galleon that Berkshire Hathaway would be making a $5 billion dollar investment in the company. A conference call of the Goldman board that Gupta attended confirming the investment ended at 3:54 pm. Rajaratnam got tipped on the deal and bought 350,000 shares of Goldman Sachs at 3:58 pm the same day. The deal was announced after the market close. Rajaratnam then exited the position when Gupta informed him that Goldman would miss its upcoming earnings estimate.
- October 2009: A Cisco executive tipped Rajaratnam that Cisco would be buying Starent Networks. Rajaratnam then purchased shares in Starent, one week prior to the deal being officially announced.
The S.E.C. and the District Attorney in New York City, Preet Bharara, built up a case against Galleon over several years, utilizing investigative tactics like wiretapping that you typically see in mafia movies. They were able to eventually convict over 20 people associated with Galleon’s insider trades.
Rajaratnam himself was arrested in October 2009 and convicted in May 2011. He was sentenced to 11 years in prison and is scheduled to be released from jail in 2021. He was also fined over $150 million for his actions. Facing a huge rush of withdrawals from investors, Galleon closed its fund shortly after Rajaratnam’s arrest.
Insider trading exists
Wall Street traders are competitive people. Many Wall Street traders are honest, but some are willing to cheat for an edge. Just like how performance-enhancing drugs tarnished baseball, Galleon Group’s insider trading shook the public’s confidence in the stock market.
To think that Galleon Group was an isolated case would be naive. There was a poll in 2013 where 250 financial professionals were polled regarding their views on insider trading. 24% of respondents stated that they would engage in illegal insider trading if they could make $10 million and get away with it.
The weak-form of the efficient markets hypothesis is not true
On an academic note, the Galleon case shows that the weak-form of the efficient market hypothesis is not true. The efficient market hypothesis states that the current price of a stock takes into account all information available about a stock at a given time.
There are three variants of the efficient market hypothesis, based on the definition of “information”. The weak-form assumes the market operates off of all publicly available information, while the strong form assumes that all information (public and insider) is used to price the market. The reality is that the market does not operate under either the weak-form or the strong-form of the efficient markets hypothesis, but something in between (the semi-strong form).
An insider trader might be on the other side of your trade
When you make a trade, you always have to ask yourself who is on the other side of the trade. Am I smarter than them? If I’m buying, why is the other side selling? The other trader may be another retail investor like yourself, but they may also be a Wall Street professional. They may have better analytics than you. They may have faster execution than you. Unfortunately, sometimes they may even have insider information that you don’t have.
By investing in index funds, you become mostly immune to insider trading
This is the most important takeaway from the Galleon insider trading case. Raj Rajaratanam was charged with making over $60 million in illegal insider trading, but he potentially made significantly more money in other undetected insider trades. Who is he making money off of? He is making money off of ordinary investors and professionals trying to beat the market.
For example, when Rajaratnam was tipped that Berkshire Hathaway was about to invest $5 billion into Goldman Sachs during the financial crisis, the people who lost money to Rajaratnam were the people who unknowingly sold their Goldman shares at 3:58 pm to Galleon, two minutes before the stock price spiked after-hours when the deal was announced.
By investing in index funds, you become mostly immune to losing money to insider traders. You invest in the entire market, and your returns are essentially independent of the performance of any individual stock. If Raj Rajaratnam or other insider traders make money on a trade, it probably won’t be at your expense.
References / Further reading
- Wikipedia profile of Raj Rajaratnam
- New Yorker feature on the Galleon case – a must read
- Selected list of suspected insider trades by Galleon – Fortune
- Galleon Group’s historical returns – Market Folly
- Reuters article announcing Rajaratnam’s conviction
- USA Today article announcing Galleon closing its funds
- Poll of financial professional’s views on insider trading – PBS Frontline
What do you think? Would you engage in insider trading if you could not get caught? Do you think investing in index fund makes you immune to insider trading? Could the underperformance of ordinary investors who trade be partly due to a culture of insider trading on Wall Street?