In a truly bizarre story, CNBC is reporting allegations that traders at SAC Capital were forced to take female hormones in order to reduce their aggression, in hopes of improving trading performance. The allegations stem from a sexual harassment suit filed by one of the hedge fund’s junior traders, who claims that “the hormones caused [him] to start wearing dresses, avoid his wife’s touches altogether and allegedly begin a sexual relationship with his boss”. The story is all the more dramatic given that the trader’s boss is Ping Jiang, a top trader with a reported income north of $100 million a year.

Sexual harassment cases are nothing new on Wall Street, but CNBC has uncovered new details of one of the most salacious cases to hit a big trading house in a long time.

The case involves a sexual harassment lawsuit filed by a Andrew Z. Tong, a former junior trader at SAC Capital, the powerful Greenwich, Conn., hedge fund, against one of SAC’s top producers, a trader named Ping Jiang.

A New York State judge has sealed the case and sent the lawsuit into arbitration, where both sides would battle it out in private. He even cancelled oral arguments that were scheduled for Thursday following an appeal by Tong’s lawyers, who want the case to remain in state court.

The judge said he sealed the details of Tong’s allegations contained in the lawsuit because it is not in the public interest to disclose the salacious nature of the complaints. CNBC has learned the suit includes the following allegations made by Tong against Jiang:

• After being hired at SAC, Tong alleges that Jiang came to him and told him he had a trading method in which his traders must not be too aggressive; that traders must be more effeminate and to do so, he directed Tong to begin taking female hormones.
• Tong says he then took the female hormones that he bought on the black market.
• Tong then alleges he suffered emotional and physical distress. The hormones, he says, caused him to begin wearing women’s clothes. He also could not perform sexually with his wife, who wanted to have a baby.
• Tong says the sexual harassment included sexual relations between the two men.

While the salacious details will certainly generate a lot of press, could it really be that giving your male traders estrogen Kool-Aid would actually improve their market performance? Let’s review the research.

In many contexts, men have been found to be systematically more overconfident than women. Among these is “Gender and Overconfidence” by Bengtsson, Persson, and Willenhag. The authors studied a Stockholm University economics exam which has an optional extra credit question, which only applies to a student’s grade if they did sufficiently well on the rest of the exam. While women overall are more likely to pass the exam, only 83.8% of them attempt the extra credit question, compared to 87.1% of men.

This type of overconfidence can induce many decision making biases which can depress investment returns. Among these are a tendency to trade too often, generating excessive trading costs, and attributing random market movements with one’s own predictive skill, which impairs learning. In a study of trading activity by 35,000 households with a large brokerage house, Barber and Odean report that due to overconfidence, men trade 45% more than women. This excessive trading reduces men’s average net returns by 2.65% a year, compared to a 1.72% reduction for women.

Let’s do a thought experiment. SAC Capital has about $14 billion in assets under management, and reportedly returned 34% in 2006. While the type of trading activity going on at SAC is far different from the household brokerage trades in the dataset studied above, let’s assume for a moment that SAC could capture the 0.93% male-female performance difference if only its traders all behaved more like women. This small performance edge would improve the fund’s returns by OVER A BILLION DOLLARS in five years.

Perhaps it’s no mystery then why a top trader would want his underlings to trade more like women. Maybe the real question then is why a hedge fund would think it was better off taking the substantial legal risk of forcing employees to take drugs against their will, as opposed to working to hire actual women — overconfidence, perhaps?

Read more:

• CNBC: Detail emerge in SAC Capital Sex Harassment Case
  
• Gender and Overconfidence, by Claes Bengtsson, Mats Persson and Peter Willenhag
• Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment, by Brad M. Barber and Terrance Odean

Earlier:

• Mars and Venus on Wall Street
• All posts tagged “gender”
• All posts tagged “overconfidence”

Would it ever be rational to buy something you know to be overpriced? Research on hedge fund trading during the dot com bubble suggests the answer is yes. Analysis of hedge fund trades on shares of inflated technology stocks shows that sophisticated investors were able to trade profitably even when the stocks were overpriced, by riding the bubble up and selling high through market timing. Stefan Nagel of the London Business School and Markus Brunnermeier of Princeton describe their research:

The premise of counter-trading by sophisticated investors “has been the main argument for why bubbles could not happen,” Nagel said in an interview. Yet, the study’s results importantly support recent theories of the limits of arbitrage. According to these theories, rational investors reasonably refuse to short or trade against even plainly overpriced securities if they believe most investors will continue to act irrationally, such that the security’s trading price will continue to rise. These, of course, are the very conditions of a market bubble.

“There is no evidence that hedge funds as a whole exerted a correcting force on prices during the technology bubble,” Nagel and Brunnermeier write. Indeed, “among the few large hedge funds that did resist the bubble], the manager with the least exposure to technology stocks—Tiger Management—did not survive until the bubble burst.” Nagel and Brunnermeier note in the study that Tiger Management was an example of a classically rational investor. Tiger declined to take major positions in technology stocks, believing them to be overpriced. While Tiger Management was proved right in the long run, its results fell far behind other funds that soared with the “irrational” approach of buying technology issues. Tiger was compelled to close up shop.

“The key to this is that if you feel you can predict what the irrational guys are doing, then it may be entirely rational to buy irrationally priced stocks,” Nagel said. In part, these possibilities arise because of time factors in hedging. Hedge traders generally are unwilling to hold short positions for a long period. Instead of betting on long-run reversal to fundamentals, they may prefer to follow short-run trends in the behavior of “noise traders,” as economists call them. “It seems that the hedge funds did exploit such a predictability during [the bubble],” noted Nagel.

The abstract in their own words:

The efficient markets hypothesis is based on the presumption that rational speculators would find it optimal to attack price bubbles and thus exert a correcting force on prices. We examine stock holdings of hedge funds during the time of the Technology Bubble on NASDAQ and find that the portfolios of these sophisticated investors were heavily tilted towards (overpriced) technology stocks. This does not seem to be the result of unawareness of the bubble: At an individual stock level, hedge funds reduced their exposure before prices collapsed, and their technology stock holdings outperformed characteristics-matched benchmarks. Our findings do not conform to the efficient markets view of rational speculation, but they are consistent with models in which rational investors can find it optimal to ride bubbles because of predictable investor sentiment and limits to arbitrage. Moreover, frictions such as short-sales constraints do not appear to be sufficient to explain why the presence of sophisticated investors failed to contain the bubble.

Read more:

• Stanford Research: Make Day Traders Act Rationally Rather Than Regulate Hedge Funds
• Hedge Funds and the Technology Bubble, by Markus Brunnermeier and Stefan Nagel