04/19/2011 10:45 pm ET | Updated Jun 19, 2011

An Outsider's Look at Insider Trading

I am fascinated by all trading (since little of it makes sense to me), but insider trading really intrigues me. Some recent cases are worthy of special attention.

In one, a hedge fund manager in FrontPoint Partners is alleged to have sold a huge block of shares in a biotech company after he got a tip that one of the company's drugs was in trouble. The sale allegedly avoided $30 million in losses. According to an article in the Wall Street Journal, FrontPoint, which was previously owned by Morgan Stanley, agreed to a settlement with the SEC involving payment of $33 million. Criminal charges are pending against the fund manager.

The fund manager, who earned a medical degree from Yale, allegedly paid cash to a French doctor who gave him the inside tip. On one occasion, he allegedly slipped $10,000 in cash in an envelope to the doctor while they were both at a bar in Milan. The French doctor has admitted his complicity in this scheme. I have to give credit to his lawyer, David Zornow, who noted that: "Dr. Benhamou's conduct in this instance must fairly be considered in the overall context of his extraordinary contributions to his patients and to medical science." How those contributions should factor into his illegal conduct is beyond me, but I thought the effort to conflate the two was very creative.

The founder of the Galleon Group, Raj Rajaratnam, is currently on trial for insider trading, as part of a broad crackdown by the U.S. Attorney Office. By some accounts, 47 people affiliated with hedge funds in the last 18 months have been charged with insider trading.

Here's what fascinates me. These are not rinky dink outfits. Galleon Group managed over $3 billion in assets. It had significant resources which -- you would think -- would permit it to do all the research necessary to uncover mispriced stocks and secure outsized returns for its wealthy investors.

Clearly, these giants of Wall Street know something they aren't telling their clients: It's really hard to be a successful stock picker. In fact, I am unaware of any research validating this skill and reams of data showing that stocks are fairly priced, incorporating all available information instantaneously. As successful insider trading indicates, it's tomorrow's news that affects stock prices. When FrontPoint got tipped off about non-public information, it was able to profit. Essentially, it learned about tomorrow's news before that news was public.

Insider trading validates index based investing. The hedge fund managers who engage in this activity understand they are unlikely to "beat the markets," without violating the law.

As noted author and market theorist William Bernstein said: " It turns out for all practical purposes there is no such thing as stock picking skill." Confronted with that reality, some managers have resorted to illegal conduct. There is a much better alternative. It will permit you to outperform 95% of all professionally managed money. Invest in a globally diversified portfolio of low management fee stock and bond index funds in an asset allocation suitable for you. Keep your cash out of envelopes. Keep yourself out of prison.

That's my outsider's look at insider trading.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.