Hedge Fund Strategies Used To Make $10 Billion

The notorious story of the “SAC Capital” Hedge Fund

In this article, we’ll uncover some of the shadiest strategies that SAC Capital used to make $10 Billion. These methods eventually resulted in the biggest insider trading lawsuit and the fund got charged and closed.

Its founder, however, managed to escape personal charges. You will find out his clever method of staying under the radar at the end of the article.

SAC Capital was the most aggressive and successful hedge fund of its time. It was created by Steven Cohen, whose nickname is Al Capone of Wall Street.

By the way, the popular TV series Billions” was based on this hedge fund and the main character was inspired by Steven Cohen.

Billions TV series SAC Capital Steven Cohen

Steven Cohen had started his hedge fund with $25 million dollars in 1992 and developed it into a $16 billion empire that employed more than a thousand people.

The hedge fund charged their wealthy clients super high commissions and fees to manage their money. Still, even after the sky-high commissions, investors received average annual returns of more than 30%. That was and still is significantly above the average returns of other funds.

The firm was shut down in 2013 after it pleaded guilty to a scandalous insider trading scheme and it had to pay $1.8 billion in penalties.

What is a hedge fund?

SAC capital hedge fund office

A hedge fund is an investment pool that’s managed by a group of individuals who are always on the lookout for outsized trading and investing returns.

Hedge funds are not regulated as strictly as banks, thus they are prone to using risky and unorthodox strategies in order to achieve high returns.

Hedge fund strategies

Hedge fund insider trading strategies used by SAC Capital to make $10 billion

There is one thing in common for all hedge funds.

They all know that information that is available to the whole public, like a company’s earnings releases, is essentially worthless if you want to make exceptional profits.

So they usually develop a set of processes and strategies to gain an edge over other less sophisticated investors.

The goal of every hedge fund is to acquire unique insights into how particular companies are doing ahead of everyone else.

And it’s hard to do it using only legal methods.

Say hello to Black Edge

At a certain point, the pursuit for an edge turns into Black Edge. Black Edge is insider information that is proprietary, nonpublic, and guaranteed to move markets. Trading on it is NOT legal.

Here are a couple of examples of Black Edge info and activities:

  • Advance knowledge of a company’s earnings.
  • Info that a chipmaker will get a takeover offer next week.
  • An early look at drug trial results.
  • Paying analysts to publish negative reports on companies to drive their stock price down.

When one trader (who wanted to remain anonymous) was asked if he knew of any hedge fund that didn’t trade on inside information, he said: “No, they would never survive!”

Black Edge is similar to performance-enhancing drugs in professional baseball and cycling. Once the elite athletes started using these substances, all others either went along with it or lost.

9+1 shady strategies of SAC Capital

Most of these insider trading information-gathering tactics were uncovered by prosecutors for the insider trading lawsuits of SAC Capital.

Such methods have been used by other hedge funds as well. And most probably similar strategies are used to this day, just more carefully.

1. Soccer-moms spying in Walmart

SAC Capital paid stay-at-home moms to walk the aisles at Walmart and report which products are selling. This might be a silly info-gathering tactic if you have two moms doing this.

But if you have hundreds or more, it can provide some actionable insights into rising or falling products and companies.

There is a high likelihood that there are hedge funds ho manage to secretly acquire similar info from supermarket workers, already nicely packed in excel sheets.

2. Laying optic cables close to stock exchanges

Hedge funds lay cables closer to stock exchanges

SAC Capital and other hedge funds spent hundreds of millions to lay their optic cables as close to stock exchanges as possible.

Why would they do that?

By having their computers closer to exchanges, the firm got price changes a few nanoseconds faster than others.

You might be wondering if 3 nanoseconds really matter? That’s close to an eternity in automated trading a.k.a High Frequency Trading.

How High Frequency Trading works

Imagine the following scenario.

If a high-frequency trader named Steven sees a stock price going up or down before everybody else, he can act profit on it.

For instance, if a retail investor named Karen wants to buy shares of Tesla and she thinks the price is $80, but Steven sees that the price has gone down to $79 in that split second while Karen’s trade order is getting executed – Steven can buy it for $79 and sell it to Karen for $80.

Steven pockets the $1 dollar difference. And if he automates these trades and makes 200k of them in a day, that’s a decent profit.

In recent years, high-frequency traders try to gain billionths of a second of advantage over rivals by using an experimental hollow-core fiber cable.

As a result of such never-ending technological advances that are first used by a few large trading firms, the playing field for retail investors is getting more unfair as they are often on the losing side of trades against HFTs.

If you want to learn the basics of stock price action without any risk and without guys like Steven milking your trades, you can check out the free stock market simulator, where you’ll get $100k of game money to invest and create a virtual portfolio of stocks, forex or crypto.

3. Scraping the data of websites and social media

Scraping the data of websites and social media

To gain insights into industries and to predict the markets, hedge funds build algorithms that crawl web pages and collect data.

For example, they can scrape used vehicle listing sites to see if there are any anomalies in the dynamics of new listing ads. If there is a large spike in cars for sale, it can signal that a recession might be on the horizon.

To uncover more methods used by pros to predict upcoming market crashes, you can read this article Stock Market Crash Prediction Signs.

Hedge funds also have systems that scan social networks in order to gauge the overall sentiment towards a certain brand or cryptocurrency, which can help them to predict which assets could rise in value and vice versa.

4. Shopping mall satellite imagery

Shopping mall satellite imagery

A select group of sophisticated hedge funds has been using the services of specialized satellite data collection companies to predict the sales of retailers.

The number of cars in a store’s parking lot lets traders reliably predict its quarterly sales. According to researchers, this information can give a 20% advantage, compared to traders who use only publicly available data.

Hedge funds spend loads of money to buy millions of satellite images of parking lots of retailers like Walmart, Target, Costco, Whole Foods, etc.

Then they use big data software and human analysts to process those images. The end data is not only highly expensive, but it takes complex skills to analyze and combine with other information sources to unearth actionable results.

Luckily for the hedge funds, it turns out that parking lot volume is such a precise gauge of retail sales that it can be used to identify errors in analysts’ forecasts before they’re announced to the public.

Here’s an example of how such a trade strategy can play out:

  1. Three weeks before a store’s quarterly earnings are published – a popular market analyst (who doesn’t have the satellite data) publishes a forecast of Walmarts’ quarterly sales. The forecast predicts that Walmart will have a good quarter.
  2. Retail investors read the forecast and buy Walmart stocks.
  3. During the two weeks before the actual earnings are published, SAC Capital requests fresh satellite data and finds out that Walmart is getting fewer customers than usual.
  4. SAC Capital shorts (bets against) the Walmart stocks.
  5. Walmart publishes sales results that are worse than expected and its stock price declines.
  6. Retail traders lose money and SAC Capital makes a profit.

Analysis of trading data shows a troubling sign – the largest part of hedge funds’ profit from these trades comes from the losses of individual investors. Retail investors are buyers of the same retailers that the hedge funds are shorting (betting against).

5. Luxury dining

Luxury dining

Extravagant dinners are a staple in the Hedge Fund industry.

Traders take out the CEOs of big companies to luxury dinners or fly them in private jets to Aspen for a weekend ski trip.

They drink together, have fun, dig for information or hope to make bonds that could lead to insider tips down the road.

6. Spotting Chinese truckers

Spotting Chinese truckers

Cohen’s fund sent spotters to China to watch trucks driving in and out of factory loading bays.

By doing so they were able to monitor the turnover of specific companies and thus forecast which company could report higher than expected results.

7. Expert networks

Hedge fund insider trading strategies - Expert networks

An expert network is a service that connects clients with individuals who are experts in their field. These individuals are usually paid for providing their services through one-on-one interviews.

Aside from facilitating the exchange of information, an expert network also takes care of the scheduling and payment processing of the interviews.

These expert networks are mostly used by hedge funds, mutual funds, and other investment firms in exchange for large fees.

The blockbuster insider-trading lawsuit of SAC Capital revealed that a number of consultants provided confidential information to hedge fund traders who bought or sold stocks based on that information.

Are all expert networks shady? Of course not.

As Columbia Law School Professor John Coffee once said:

“I’m not saying there aren’t legitimate expert networking firms, but they are a little bit like putting a group of teenagers together in one room with a lot of booze — something is going to happen.”

8. Hiring friends of insiders

Insider trading Hiring friends of insiders

Cohen would hire traders who had some access to managers of the biggest companies.

For example, his firm hired a trader who had rented a summer house with the CFO of a publicly-traded company as he could potentially get some inside info.

9. Building fake friendships with big pharma employees

Insider trading pharma company bapi sac capital

Some SAC Capital traders spent years befriending employees at pharma companies.

For example, one of Cohen’s portfolio managers named Mathew Martoma had befriended Gilman, a 76-year-old employee of a pharma company who was developing a drug that could potentially cure Alzheimer’s disease.

Gilman didn’t have a son and had a false sense that their friendship was real. Martoma had been receiving secret inside info about the drug’s clinical trials for two years.

After secretly finding out that the drug trials didn’t look good, the fund shorted the pharma stock and made approximately $275 million in profit.

That year, Martoma received a bonus of $9.3 million. He was later accused of using this confidential information about the drug to create the most profitable insider-trading scheme in history.

10. Black PR

black PR

One of the darkest known tactics used by SAC Capital was paying analysts to publish negative reports on companies to drive its stock price down. They organized a negative review from analysts and before the publication of that review, they shorted the stock and profited from the decline of the stock price.

They also paid analysts to receive true research before it gets published. For example, Citigroup analyst K. Chang emailed unpublished research about Hon Hai Precision Industry Co (a major supplier of Apple Inc iPhones) to SAC Capital and three other hedge funds.

Chang’s research included lower than expected order forecasts for Apple’s iPhone sales in the first quarter of 2013. This data had a negative effect on Apple. Citadel was fined $30 million for this inside info leak.

How hedge fund owners avoid getting caught

How hedge fund managers avoid getting caught

SAC Capital came up with a clever system to protect Cohen from getting caught in insider trading.

When traders sent their insider tips to Cohen, they didn’t mention how or where they obtained the info. Instead, they used a conviction rating system of 1-10 where 10 was used for “absolute certainty”, a level impossible to achieve without insider information.

Traders sent insider tips to Cohen by using this numbered “conviction rating” to depict how sure they were about the value of the tip. This way traders communicated the value of their information to their boss without exposing him to details of how they knew something.

How insiders deliver info to hedge fund traders

How insiders deliver info to hedge fund traders

Dealing with insider information can get you jail time, so naturally, insiders try to invent various ways to deliver the secret info to the hedge funds.

Here is one example of how one analyst called Munro sent insider info to Barai, a trader from SAC Capital.

  1. Munro created an email account JUICYLUCY_XXX @yahoo.com.
  2. Shared the username and password with Barai.
  3. Munro composed emails containing inside information about Cisco and other companies. But would leave them in the drafts folder, where they supposedly would not create an email trail
  4. Then Munro sent Barai an email: “Lucy is wet”.
  5. Barai would log in and read whatever was there.

The bottom line

For decades, top investors and traders have been striving for an information edge that would let them outperform others by even the smallest margin. That’s the essence of Wall Street.

Even though the U.S. Securities and Exchange Commission has made detection and prosecution of insider trading one of its top enforcement priorities, it’s unlikely that hedge funds will stop trying to get ahead of the market using grey tactics.

Most likely they will become more cautious and focus more on strategies that are based on technological advantages.

Luckily for wealthy investors, the rise of technology and big data is progressively blurring the boundaries between private and public information.

They can use artificial intelligence to analyze market sentiment from social media or satellite data – and it would not be considered illegal.

That is public information after all, but it can be accessed only by those who have enough resources and technical expertise to process such vast amounts of data.

As a result, even as technology has made trading accessible to everyone with a smartphone, the rise of big data is creating what is called Alternative Data that only those with deep pockets can tap into.

If it was just a transfer of wealth between large investment firms, that would be one thing. Unfortunately, it’s the small retail traders and investors who are usually on the other (losing) side of the trade.

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Daniel Ug
Daniel Ug

Co-founder at Three Investeers and Stock Market Simulator Game. Daniel has a Bachelor's degree in Finance & Information Technologies from BA School of Business and Finance, Latvia.

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