05/17/2011 01:39 pm ET | Updated Jul 17, 2011

The Victims of Insider Trading

Nothing surprises me more than when I read that trading on insider information is a victimless crime. In the wake of the conviction of hedge-fund giant Raj Rajaratnam, the claim has come up time and again. In fact, it is entirely untrue. The victims are all those who sold Raj a stock or other security at a lower price than they might have if they had the same information he had. In other words, the victims are pensioners, mutual fund investors, bank trusts holders, and on.

It's like what happened in the 1800s when some insiders knew the railroad had planned to build a track through a certain territory. They bought land from unsuspecting farmers, ranchers and maybe even the federal government on the cheap. That activity disgusts us. Same with stocks when the fund managers know about good earnings news to be reported the next day or a merger announcement to come.

What the details of the Rajaratnam scandal also shows is that he who pays the most money for inside information also makes the most money. Money begets money, the big get bigger. That's a pretty good example of what's happened over the past thirty years in American finance.

Now, when you can leverage that money up -- borrow to the hilt at low rates -- inside information really pays off. Many hedge-fund managers don't make money for the insights but for their sheer chutzpah. Meantime, market integrity is out the window.

Wall Street's always had some kind of advantage over the rest of us. The pros could often call someone up at a company to get an edge. But passing out outright inside information -- the kind that will move a stock price one way or the other substantially -- should clearly be illegal.

One of the more interesting facts about hedge funds is that, according to those who measure risk statistically by deriving 'betas' and 'alphas,' they do better on average than the amount of risk they take suggests they should. Mutual funds on average do not.

Some interpret this as proof of how astute the hedge funds are compared to other investors. The data could also be interpreted another way. That given their size and wealth, they have more information about company strategies and results, takeovers, and the trading patterns of the market. They may even be able to push prices their way and bail out before others catch on. Cornering markets can be against the law. How often does "mini-cornering" -- momentary attempts to buy enough supply to determine a quick price change -- go on? That's perhaps the main reason why they do better than the risk they take suggests they should.

This is seedy stuff and there is no simple way to prevent it adequately. If such practices are common, it makes good sense for investors who have the money to sign up with hedge funds and get a piece of their unfair advantage.

On the other hand, some hedge funds are totally honest. How can we tell which ones make it on smarts, good instincts and genuine preparation? Only if the government aggressively cleans up the act. Fear of prosecution is perhaps the only effective weapon.

Meantime, good money flows to funds, often unwittingly, who exploit and take advantage -- and that only distorts the efficient allocation of capital in America.

Cross-posted from New Deal 2.0.