Hedge funds on insider probe: Bring it on

December 6, 2010, 10:48 PM UTC

Although the insider trading investigation is still in early stages, some fund managers are already positioning their firms to attract new clients from its wreckage.

By Cyrus Sanati, contributor

Think the insider trading probe is bad for all hedge funds? Think again.

With the latest investigation centering on providers of research to hedge funds, some managers of quantitative funds, which rely solely on computer algorithms for trading ideas, are hoping to cash in on the imbroglio and pick up new clients. Similarly, large hedge funds are planning to use their extensive compliance departments as an important differentiator from the funds at the center of the probe.

The government investigation is currently focused on firms that use unorthodox research tactics — outside research firms and so-called “expert networks” — in the quest to generate alpha, or returns uncorrelated to the market. Ordinarily this kind of research was thought to be good for stock picking and due diligence, but the government seems keen on proving that some hedge funds, as well as some large mutual funds, may have crossed the line in soliciting insider information in the quest to gain an edge over other investors. So far, mutual funds such as Janus (JNS) and Wellington have been subpoenaed, as well as hedge funds including SAC Capital and Citadel.

To be sure, it is unclear if the firms the government is investigating will be charged with any wrongdoing. After all, insider trading is very hard to prove given the complexities of the law. For example, if the firm came into the information through legitimate research using legal means, and the firm didn’t have a fiduciary duty to the company to safeguard that information, they would legally be free to trade on it.

Nevertheless, even the appearance of impropriety on the part of a fund is enough to send investors bolting for the exits. Some large asset managers are actually required to withdraw their cash out of a fund if it is being investigated by the government. Hedge funds outside of the investigation are hoping to capture those investors.

Some quant-based managers that spoke to Fortune on background are convinced that this investigation will be good for their business. These funds don’t use research – they rely on technical indicators based on market movements for their trades.

Since they don’t need or want insider information, quants believe they are largely immune from this particular government probe. Some managers confirm that they’ve received inquiries from investors looking to move their funds from a traditional hedge fund to a quant fund as a result of the investigation, but they say the investors are still cautious about making the switch – at least for now.

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But quant-based funds are not the only hedge funds that are positioned to potentially benefit from this investigation. Some multi-strategy hedge funds and fund-of-hedge funds are stressing the importance of their strong compliance departments and largess to show that they’re above board.

“We have not gotten any nervous calls from our investors on this matter,” Glenn Dubin, the chief executive and co-founder of Highbridge Capital Management, the $21 billion hedge fund inside JP Morgan (JPM), told Fortune. “I think that’s because our legal and compliance departments have always taken it one step above in terms of taking safeguards and making sure we communicate properly with our investors.” Highbridge has not received a subpoena in the current probe, according to Dubin.

Dubin later told an audience of hedge fund executives at the Bloomberg 2010 Hedge Fund conference last week in New York that he thought all the government scrutiny “favors bigger firms,” and that he sees more consolidation in the sector as large asset managers gravitate toward funds that appear to be more institutional in nature.

“The SEC is under a lot of pressure to find villains in our industry, and if they look hard enough they will probably find enough rogues,” the head of a major hedge fund group, who did not wish to be indentified due to the sensitive nature of the investigation, told Fortune. “Short term this is going to be very bad for our industry, but in the long term it could be a blessing to some of the more established firms with strong compliance departments.”

Anthony Scaramucci, the outspoken founder of Skybridge Capital, the hedge fund seeding group, believes that his efforts to mutualize the industry through his new retail fund of funds business will also benefit from this trouble.

“We have put together an institutional framework with a compliance system where the presumption is that the managers who want access to our capital are considered guilty until our staff and our group of outsourced private investigators proves that manager innocent,” Scaramucci told Fortune. “So investors who want to get exposure to the hedge fund industry and don’t want to get caught up in bad things will probably want come through vehicles like ours.”

Although the scope of the investigation is still unknown and its impact on the hedge fund industry may still be years away, one thing is certain for the money management industry: for every loser, a new winner will emerge.

Also on Fortune.com:

The six degrees of Steve Cohen

Who is an insider, anyway?

SEC breaks up in-law insider trading ring