Galleon trial showcases a classic — and dwindling — type of hedge fund

Reporting from New York — A criminal trial starting this week is shaping up as a classic story of hedge funds gone bad, but the topic — stock trading — no longer typifies the increasingly risky investments of the fast-evolving hedge-fund world.

The case against Raj Rajaratnam, founder of Galleon Group, promises the staples — major companies, prestigious executives, incriminating wiretaps, informants and secret phone calls providing hot tips on stocks.

Although this story may resonate with the public’s perception of what hedge funds do, it is at odds with the complex and high-tech direction hedge funds have been headed for the last two decades.

At many of the most successful new funds, trades are made based on complex algorithms rather than financial documents — and bonds, commodities, currencies and derivatives far exceed stocks as the securities to exchange.

“There will always be a role for stock picking, but it’s definitely one that’s diminishing,” said Marc LoPresti, a lawyer who represents hedge funds that use a number of investing strategies.

“Why aren’t they [regulators] looking at the algorithmic and high-frequency traders? The answer is that they really don’t know how to regulate it and they really don’t know how to enforce it yet,” he said.

The trend has been to rely less on stocks. Roughly 22% of hedge funds primarily used conventional stock-picking strategies last year, down from about 36% in 2002, according to data from research firm Barclay Hedge in Fairfield, Iowa.

The federal government has investigated mostly stock-oriented funds, including Galleon and SAC Capital, a well-known stock-picking hedge fund where two former employees face government charges.

Jury selection in the Rajaratnam trial begins Tuesday, and the case is expected to last as long as two months. The witness list includes Lloyd Blankfein, chief executive of Goldman Sachs Group Inc.

Authorities listened in on hundreds of hours of Rajaratnam’s conversations that, they allege, suggest that Rajaratnam got early tips about financial results at companies such as Intel Corp., Google Inc. and IBM Corp. He is accused of earning more than $45 million in “illicit profits” from his trading. He has denied any wrongdoing.

In its long-running investigation into insider trading, the government has charged 25 people with insider trading at hedge funds, and 19 of them have pleaded guilty, including some of Rajaratnam’s closest associates.

In a civil lawsuit last week, the Securities and Exchange Commission accused Rajat Gupta, a former Goldman director, of using his board positions at the Wall Street investment bank and at Procter & Gamble Co. to pass confidential information to Rajaratnam, his friend. Gupta denied any wrongdoing.

U.S. Atty. Preet Bharara, who has led the criminal investigations, said last fall that “illegal insider trading is rampant.”

The government’s decision to go after insider trading at hedge funds is notable because it has had relatively few other successes in prosecuting large financial crimes since the global financial crisis.

William Black, a former regulator who helped uncover the savings and loan crisis, said the government appeared to be going after the easiest crimes to prosecute rather than the biggest risks to the financial system.

“There are spectacularly few resources to go after white-collar crime, and the government uses the few resources it has in a spectacularly poor fashion,” said Black, who is now a professor at University of Missouri-Kansas City. “An insider-trading scandal is bad, but it is not the thing that is going to cause a systemic crisis.”

The hunt for good information about company stocks was present from the earliest stages of hedge funds in the 1940s. The original funds hedged their exposure by “shorting” stocks, or betting that share prices would go down.

In the 1970s, hedge funds invested in commodities, such as wheat and gold, to temper the stock market’s volatility. In the 1980s, currency traders such as George Soros became hot.

More recently, the biggest growth has come from hedge funds that employ math geniuses to capitalize on unnoticed inefficiencies in the market. Many of these funds don’t touch stocks, and those that do generally have little use for information about specific companies.

“A large share of hedge funds trade bonds, currencies, commodities or derivatives,” said Sebastian Mallaby, author of “More Money Than God,” a history of hedge funds. “Their strategies would not be boosted by inside information from companies.”

Some sophisticated hedge funds have proved dangerous to the financial system in the past. In the 1990s, the government brokered a bailout of Long-Term Capital Management after it made a series of ill-advised, heavily leveraged bets on government bonds.

Two hedge funds at Bear Stearns Cos. bet heavily on mortgage-backed securities, contributing to the investment bank’s downfall in 2008.

More recently, high-frequency traders took some of the blame for the so-called flash crash last May, in which the Dow Jones industrial average plunged nearly 900 points in 15 minutes.

Regulators should spend more time looking at the dangers arising from these newfangled funds, said Marshall Auerback, who works at Madison Street Partners, a hedge fund in Denver.

“You are always responding to the last crisis, not anticipating the next one,” Auerback said. “Is this the really big problem [prosecutors] should be focusing on right now? Probably not.”

The investigations have given the hedge fund industry a black eye and led investors to withdraw money from firms that received subpoenas — even those that have not faced any charges of wrongdoing.

Beyond the hedge funds involved, though, the investigations do not seem to have damped investor enthusiasm.

Hedge funds saw an overall inflow of $55.5 billion last year; in the previous two years, investors took a total of $285 billion out of hedge funds, according to data from Hedge Fund Research.

nathaniel.popper@latimes.com