Dodgy deals threaten top hedge fund

Ground Floor Sheila O'FlanaganThe complex area of hedge fund trading has made its way into the news again with the story of Canary Capital Partners.

Hedge funds, as many of you know, claim to be able to make a profit for their clients in any type of market as they use a variety of techniques in their trading to take advantage of both gains and falls.

A perfect hedge, of course, would actually mean that potential profits and losses would wipe each other out and so make no money at all. What the traders usually do is to hedge different instruments so that they exploit the difference between, say, equity markets and bond markets to make money. (Usually when one is performing well the other is performing poorly.)

Anyway, the traders move huge amounts in and out of the markets and can themselves make prices move because of the type of trades that they do. Where they deliver bang for the buck is that they usually leverage very highly (by borrowing) to increase their potential investment return; and because of the high-risk nature of the trades that they ultimately engage in, private investors are normally priced out of the market. At least, the average private investor is. If you've got half a million to spare you just might get your toe in the door.

Edward J Stern had plenty of money to spare since his Dad was a billionaire real estate developer, and so Junior set up Canary Capital. He invested his own money in trading and then started to attract outside investors too.

Canary (apparently so named after the canary feed that the family used to sell) did pretty well after an average start. By 1999 the return on the fund was 110 per cent - guaranteed to keep you in bird feed or property or just about anything else. In 2002 the returns were less impressive although a 15 per cent gain when the market was down 23 per cent was still satisfying enough. However, in 2003 the fund wasn't doing too well and Stern suddenly told the investors to take their money out.

What has now been uncovered by New York Attorney General Eliot Spitzer (who has been going through Wall Street like an avenging angel) is that Canary Capital was being allowed to buy mutual fund shares after market closing, but at the price being charged before the close. This meant that Stern could make money out of any news that came out after the bell. Apparently Canary was also allowed to make quick in and out trades out of funds that other investors can't do.

The highest profile funds in which Canary traded were managed by Bank of America and apparently the reason that Stern could make the trades was that the bank (and others) allowed him to do it in return for the size of the investments he made with them. This would be all very well in a you scratch my back and I'll scratch yours' sort of way if it wasn't for the fact that, by offering Canary preferential treatment, other investors were actually losing out. And most of those investors would be private individuals who had put money into mutual funds as a way of spreading their own risk in the market and saving for their futures.

Now the bird feed has hit the fan and there's a feeling around that Canary weren't the only ones who were zipping in and out of the market. Although mutual funds say that they discourage late trading and short-term market timing by big investors, it looks as though the practice is endemic and that some mutual fund managers did allow those trades to take place in exchange for other payments. It stinks of course and is yet another stick to beat Wall Street over the head with.

The revelations couldn't have come at a worse time as the NYSE's role as a regulator is being called into question by Spitzer, while the size of its chairman, Dick Grasso's pay package is being hotly debated. In an apparent attempt to deflect attention away from the amount of his so-called 'compensation', Grasso announced that he had turned down an additional $48 million (€43 million) that had been due to him. An additional $48 million! I wasn't the only one shocked to learn that, without it, he was still earning $140 million. Interestingly, Grasso was paid a mere $6 million in 1998. He almost doubled that the following year and doubled it again the year after, although in 2002 (perhaps because it was such a dreadful time for markets), he was back to $12 million.

The money he's now getting includes a certain amount that he had deferred from previous years (nice to be able to do that in the first place but the methods by which it was done are also being questioned) as well as retirement payments and interest (although he's not planning to leave the exchange before the end of his contract in 2007).

The rationale for the huge amounts? Well, the value of seats on the exchange has soared under his chairmanship - from $760,000 in 1994 to more than $2 million now. So the price of a seat has gone up 163 per cent. Grasso's compensation has increased by 2,233 per cent. Unlike many observers, Grasso thinks that his main function at the NYSE is to increase the value to the 'shareholders' - those people who own seats. He says he's a businessman first, regulator second. Seat-holders might agree. Investors don't.

The ordinary savers, on whom in the end so many of Wall Street's finest depend for their careers, want to know that people aren't making a quick buck on the back of their hard-earned savings. The American dream might be for the regular guy to do well - but not at the expense of everyone else.

Grasso has done spectacularly well. But, under his watch, many Americans have seen capitalism bite the hand that feeds it. Who can blame them for wanting to bite back?