Why the Feds want Steve Cohen

November 24, 2010, 1:10 AM UTC

Just as all roads lead to Rome, all insider trading investigations lead to SAC Capital’s Steve Cohen. He can’t shake the Feds because he’s too good to be true.

When word got out that FBI agents raided three hedge funds on Monday in the ever-expanding insider trading investigation—Level Global Investors, Diamondback Capital Management, and Loch Capital Management—it didn’t take long to connect the dots to the person that all of Wall Street is talking about: two of the three funds are run by former managers of Steve Cohen’s SAC Capital Advisors.

While this investigation appears to be sweeping, Cohen is the real story here. You’ll never hear it from the Feds themselves, but their actions speak louder than the words they won’t say: they want more than anything to nail Cohen for insider trading. They’ve been here before, and have consistently come away empty-handed. But they’re back again: MarketWatch reports that SAC has informed its investors that it has received an “extraordinarily broad” subpoena from the authorities.

Defenders of Cohen will tell you he’s been relentlessly pursued because of his success, that this is tall poppy syndrome in plain form. Steve Cohen is the best hedge fund manager going, they will argue, and for that he is a target.

The characterization of Cohen as the best is pretty much true (who else can claim 30% annualized returns since 1992?), but the reasons behind the obsession with finding something to pin on him are subtler than that. And the primary one is this: as humans, we tend not to accept something that we cannot understand. When we can’t explain something, we sit in disbelief. And because he is a trader above all else, it’s hard to explain Cohen’s enduring success. (A spokesman wouldn’t explain it to us, either. Cohen’s outside PR representative declined comment.)

Here is what he is not: he is not Warren Buffett, arguably the best investor in history. Buffett is a fundamental investor, a man who takes deep, long-term views on the prospects of one company or another, and then tries to pick his entry point when he’s got a large “margin of safety” as protection. It’s not difficult to understand why Buffett’s early investments in the likes of Coca-Cola (KO), Wells Fargo (WFC), and American Express (AXP) have paid off over the long haul.

Cohen is also not Marc Lasry of Avenue Capital, an investor who specializes in so-called distressed investments. When you’re a distressed investor, you not only have to have a well-thought opinion on the prospects of a company, you also need to know your way around the capital structure. Size and experience go a long way in the distressed realm, and the big can get bigger by virtue of that edge. When Lasry tries to take control of Donald Trump’s bankrupt Atlantic City casinos, we can understand where he’s coming from: the assumption that a serious human being could run Trump’s casinos better than the Donald himself.

Finally, Cohen is not James Simons of Renaissance Technologies, the king of the quantitative investors. While SAC Capital may use some trading algorithms in its day-to-day, Cohen’s is not a black-box operation, with software designed and constantly tweaked by a squadron of PhDs like those that work for Simons. We may never learn what Simons’ algorithms actually are, but we do accept that computers can outperform humans at quantitative tasks.

Just a trader?

Cohen, in short, is a trader. According to one knowledgeable investor, Cohen has called what SAC does “information arbitrage.” He and his staff are simply whipping stocks around on a day-to-day basis, trying to get an information edge over the guy on the other side of the trade. If that sounds fundamentally useless, that’s because it is. There’s been a lot of talk these days about whether there is any redeeming value to Wall Street whatsoever. Even among those who think there is, the trader is widely considered mere grease for the wheels of finance, an essential if undesirable part of the machine.

Still, it’s not difficult to admire great calls. When we see someone risk it all and win on the big trade—think John Paulson and U.S. housing—we can all sit back and envy. But when we see someone make the right call on bigger and bigger trades for nearly 20 years running—and deliver 30% returns even after charging an absurd 3% of assets and 35% of profits as Cohen does—it’s not envy that is the instinctive response; it’s disbelief. No one, the thinking goes, can be that good—and that lucky—for so long. Ergo, he must be cheating. Specifically, engaging in insider trading. And that’s why they’ve been after him for all this time.

Laying the blame for the ethical or legal failures of ex-SAC Capital employees on Cohen’s own doorstep isn’t really fair, in the strictest sense of the word. And the Feds have not accused him of anything this time around, at least not yet. That said, where there’s smoke, there is often fire, and it’s pretty hard to ignore just how often SAC comes up when the subject is insider trading.

Chip Skowron of FrontPoint Partners—he of the Albuferon tip—is a former SAC employee. Richard Choo-Beng Lee of Spherix Capital—who has pled guilty in the Galleon investigation—is also an alumnus. John Kinnucan, the researcher who emailed his clients about a visit by the FBI as part of this current probe, counts SAC among them. In divorce papers, Cohen’s ex-wife Patricia has even suggested he used to brag to her about ill-gotten insider trading gains.

And now, we can add to it all the investigation of Level Global’s David Ganek, a fixture in the monied Manhattan art and social scenes and thus a big fish in his own right. You’d think the authorities would be satisfied with a trophy of that size, but when you really think about it, bringing to heel the husband of the author of the not-critically-acclaimed The Summer We Read Gatsby doesn’t really have the same ring as taking down the most legendary hedge fund manager in history next to George Soros.

Here’s my bet on how this is going to play out. In the next year or two, Cohen is going to retire. In the process, he will likely wind down SAC—a huge proportion of which is his own money in any event—and will amuse himself with his gigantic art collection, doing things like selling a Manet for $33.2 million, as he did this past June. He will tell people he has nothing left to prove, and that the constant hounding by the authorities took all the joy out of the thing.

And he may be telling the truth. Either that, or the Feds will have finally driven home the fact that the game can no longer be played the way he just might have been playing it all along. In which case, what’s the point of doing it at all?

More on Fortune.com:

How expert networks came to dominate Wall Street

Trading probe deep-sixes Goldman rally

Insider trading by hedge funds? I’m shocked! Shocked!