Tuesday, December 14, 2010

HBR: "How Hedge Funds Create Criminals"

From the Harvard Business Review's The Conversation blog:

Hedge funds are playing the role of Wall Street villain again. This time, the charge is rampant insider trading. First came the 2009 arrest of Raj Rajaratnam, founder of the Galleon Group. Then came the November 22, 2010 raids of three hedge fund headquarters by FBI agents who seized documents and confiscated BlackBerries. Now authorities are serving subpoenas on other, larger hedge and mutual funds. Attorney General Eric Holder has announced the government's widening investigation is "ongoing" and "very serious." (Recently, though, Jesse Eisenger in the New York Times called these investigations a "side show.")

These events and allegations raise suspicion that some hedge fund traders may have succeeded at beating the market not through careful research and original analysis but allegedly by breaking the law. The question, then, is, Why does a portion of the hedge fund industry stand accused of succumbing to illegal behavior?
I would argue that it's not so much about misaligned incentives, as we might guess from standard economic theory, but rather because, from a behavioral perspective, my research suggests that hedge funds are "criminogenic" environments.

The Science of Prosocial Behavior
Economic theory treats people as rational, selfish actors who would not hesitate to break the law or exploit others when it serves their material interests. Luckily, behavioral science (and everyday experience — mostly) teaches this trope simply is not true. Innumerable experiments and field studies have proven that people often act "prosocially" — unselfishly sacrificing opportunities for personal gain to help others or to follow ethical rules. Few people steal their neighbor's newspapers or shake down kindergartners for lunch money.
My research, shows that people's circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.
Killing Conscience
Hedge funds, both individually and as a group, can send at least three powerful social signals that have been repeatedly shown in formal experiments to suppress prosocial behavior:
Signal 1: Authority Doesn't Care About Ethics. Since the days of Stanley Milgram's notorious electric shock experiments, behavioral science has shown that people do what they are instructed to do. Hedge fund traders are routinely instructed by their managers and investors to focus on maximizing portfolio returns. Thus it should come as no surprise that not all hedge fund traders put obeying federal securities laws at the top of their to-do lists.

Signal 2: Other Traders Aren't Acting Ethically. Behavioral experiments also routinely find that people are most likely to "follow their conscience" when they think others are also acting prosocially. Yet in the hedge fund environment, traders are more likely to brag about their superior results than their willingness to sacrifice those results to preserve their ethics.

Signal 3: Unethical Behavior Isn't Harmful. Finally, experiments show that people act less selfishly when they understand how their selfishness harms others. This poses special problems for enforcing laws against insider trading, which is often perceived as a "victimless" crime that may even contribute to social welfare by producing more accurate market prices. Of course, insider trading isn't really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it's easy to mistakenly feel that insider trading isn't really doing harm....MORE
HT: Dr. Hazlett who has an egg noodle recipe on her blog while sending me the above and this snippet:
"On the whole, free atmospheric winds at mid- and high-latitudes are predominantly quasigeotrophic, thus established and maintained by baroclinity, which when time-averaged tends to follow the diminishing poleward temperature gradient."
Thanks Doc.