New Clues About How Hedge Funds Make So Much Money

We all wonder why Wall Street pros make so much more money than everyone else. But investment bankers are pikers compared to hedge fund managers, who make their money by taking a small cut of the assets they attract as well as a larger slice of the profits they earn in a given year. The higher their profits, the more money they make. That gives them a huge incentive to take risks and -- in some cases -- engage in illegal insider-trading.

Now, a probe by Federal investigators is indicating one way they might be able to find those inside tips. The Wall Street Journal reports that a three-year Federal investigation is about to culminate in indictments related to hedge funds using so-called expert networks -- research firms that specialize in finding executives who will dish on their industry to investors for a few hundred dollars an hour. In this investigation, the expert networks may have helped investors get inside information about health care mergers before they had been publicly announced.

Focus on Health Care Deals

Details are fairly sketchy at this point but the investigators are collecting evidence to show courts that the hedge funds paid experts who tipped them off to pending mergers, the Journal reports. Those investigators will have to prove that the hedge funds then bought shares in the targets before the mergers were announced.

Investigators are also looking into whether investment bankers tipped off investors about pending mergers. Specifically, the Journal reports that Goldman Sachs (GS) is being investigated to find out whether its health care bankers tipped off some investors -- possibly hedge funds -- to pending health care mergers.

Why would the bankers do this? No answers are available but there are two possibilities that come to mind. The first is that the bankers could have had investments in the hedge funds. The second is that their bosses asked them to do it in order to boost their ties to the hedge funds that do their trading through Goldman.

Remember Galleon?

If this all sounds familiar, it should. That's because Raj Rajaratnam, who ran a $3.7 billion hedge fund, Galleon Group, was previously indicted for insider trading. As I posted on Daily Finance in April 2010, Galleon allegedly used inside information to make money trading in technology and other stocks. He is to go on trial in 2011.

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The investigation dragged down a director from the international consulting firm, McKinsey & Co., Anil Kumar, as well as Rajat Gupta, a Goldman director who had previously served as McKinsey's worldwide managing director. This raised questions about whether the world's most elite consulting firm and its premier investment bank were profiting from their inside knowledge of mergers -- using hedge funds as the conduit for their trading.

The latest investigation is also pulling in Todd Deutsch, a Galleon Group alumnus who left in 2008 to go out on his own. Deutsch, "has specialized in health care and technology stocks," according to the Journal.

If the Journal's reporting is accurate, the coming weeks could yield some stunning revelations about widespread insider trading. This does nothing to boost the public's confidence that their retirement money is in good hands.

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