A version of this was originally posted to the TMN newsletter in December, after insider trading charges were filed against former SAC Capital fund manager Matthew Martoma. The same points are relevant now, in the wake of the latest SAC-related charges.
Why is Steven A. Cohen’s SAC such a tempting target for prosecutors? Despite a great deal of effort, prosecutors haven’t found evidence linking Cohen directly to insider trading.
So why do they deem to be looking so hard? Yes, Cohen is well known and successful; so are other fund managers. The difference is that we have a pretty good idea of roughly what other successful fund managers do. There are a few approaches that seem to account for outsized returns:
* Work off an understanding of macro-economic trends that is simply consistently correct than that of other investors. This is what George Soros did for many years, and what John Paulson does, not always successfully.
* Invest with a long time horizon, finding value that other investors miss. This is what Bruce Berkowitz has done with the Fairholme Fund (if you missed this Bloomberg story about Berkowitz, go back and read it right now). There may be a few efficient-markets zealots who will say this is theoretically impossible. It’s not.
* Model the market with algorithms better than other investors to take advantage of price discrepancies. Some variation of this probably drives the returns of Jim Simons’s Renaissance Technologies LLC.
* Trade with borrowed money to boost your returns. Almost every hedge fund does this to some degree. This will always work as long as the market moves with you; without another edge, it will also eventually make you blow up.
Cohen has certainly tried all these approaches. What his fund is best known for, however, is stock picking. As this 2010 Bloomberg story describes, Cohen’s main business is trading stocks (in 2008 he shut down efforts in other classes) and holding them for periods of 2 to 30 days.
With other top investors, the outside world has some sense of what makes their strategy different from everyone else’s. Not so with Cohen. There may be a general explanation for why he outperforms his peers. Cohen and his staff may have a markedly better understanding of the market’s psychology, for instance. Or a better framework to evaluate the quality of publicly available information.
The difficulty here is that in other hands the approach of guessing which stocks will go up in the next week or month reliably fails to beat the market. So far, Cohen has never really articulated what makes his firm different from all the other stock pickers out there. That may be one way to dissolve the cloud of doubt that has settled over SAC.
Postscript: One data point worth noting, for those who want to dive deeper, is that the latest SEC filings for Berkowitz’s Fairholme Capital Management show investments in just 15 companies. That’s it. Picking just a few stocks that will beat the market is hard enough; any strategy that picks hundreds of winners will raise questions. Also, one approach not mentioned here that has been in the news a lot lately is Carl Icahn’s investor activist approach. Clearly that’s another strategy that works, but again, very different from the kind of stock picking that SAC does.