How hedge funds use market intelligence and where the line is

Hedge funds are paid to know things before the rest of the market does. That is the whole premise of the two and twenty fee structure. A private investor opens the paper over a cup of tea and reads what is already priced in. A serious hedge fund wants to act on information the paper has not yet printed, and on patterns that only become obvious if you are willing to pay for the data, the analysts and the time. The question that matters is where the legitimate version of that effort stops and the illegal version begins.

The legitimate version has a name. It is called the mosaic theory. The idea is that you can build a clear picture of a company by assembling small pieces of public or semi public information, none of which would move a share price on its own, into something that does. You read the annual report. You walk the factory carpark to count the lorries. You speak to a distributor, to a former employee, to a retired industry analyst, to a supplier in a different country. You look at satellite photography of oil storage tanks and car parks. You buy anonymised credit card panel data. You pay an expert network to introduce you to a semi retired engineer who can explain why the new product is a better bet than the old one. None of those steps gives you privileged information. The edge comes from having the resources to assemble them and the judgement to weight them correctly.

The illegal version is insider dealing. It is when the edge comes from non public price sensitive information that has been passed to you, knowingly or otherwise, by someone under a duty of confidence. In the United Kingdom the Financial Conduct Authority pursues these cases under the Market Abuse Regulation that has applied here since 2016, with some post Brexit amendments. In the United States the reference case is still Raj Rajaratnam, the Galleon hedge fund manager whose 2011 conviction produced an eleven year prison sentence and demonstrated that expert networks could be used as conduits for stolen information rather than for legitimate research. British investors should note that the FCA has continued to bring cases of its own. Recent prosecutions have centred on friends and family trading ahead of announcements, and on professionals inside banks and advisory firms who passed tips to associates. The amounts are often small by Wall Street standards, but the sentences are serious and the reputational damage ends careers.

The grey area between the two is where most of the interesting work happens. A call with a former executive about the direction of an industry is research. A call with a current executive about unpublished numbers is a crime. An expert network that vets its consultants properly and bars anyone from discussing current material information is a legitimate service. One that turns a blind eye becomes the courier service that hanged Galleon. The individual analyst is often the person making the call, in real time, about whether a conversation has crossed the line. That is not a theoretical problem. It is a live risk that has to be managed every working day in every serious fund.

Short selling sits inside this same story because it is the other great source of hedge fund edge. The short seller borrows a share, sells it, and hopes to buy it back cheaper later. That is an unpopular activity to defend in public, because it looks like profiting from failure, but its function in the market is not sinister. Short sellers are often the first people to dig into the numbers of a company that the rest of the market wants to believe in. When they are right, price discovery happens faster and capital moves away from businesses that should not have it. When they are wrong they lose money, and unlike a long only investor their losses are not capped at the amount they put in.

The most influential short selling campaigns of the past decade have been run by firms that publish their work. Muddy Waters, run by Carson Block, targeted the UK listed litigation finance firm Burford Capital in August 2019 with a report that took the share price down by more than half in a session. The company fought back hard and the episode is still debated in the City, but it showed how a single published note from a credible short seller could move a FTSE 250 stock in minutes. Hindenburg Research, before it wound down in early 2025, used the same playbook on a global scale, most famously on the Adani group in 2023. The Wirecard collapse in 2020, triggered in part by persistent work by journalists at the Financial Times alongside short sellers betting against the stock, is the European case study that every new analyst is now taught. The lesson is not that short sellers are always right. The lesson is that when the work is good, they move prices quickly and regulators eventually catch up.

The other lesson from the past few years is how quickly concentrated hedge fund positions can unwind. The collapse of Archegos Capital Management in March 2021 was not a conventional hedge fund failure. It was a family office run by Bill Hwang, who had already settled an insider dealing case with US regulators a decade earlier. He built enormous leveraged positions in a handful of stocks through total return swaps with his prime brokers, so the positions did not show up on normal disclosure filings. When the underlying shares fell, the margin calls hit the banks rather than the fund, and several of them lost billions between them. Hwang was later convicted in 2024 on fraud and market manipulation charges. The episode did not tell us anything new about short selling or mosaic theory, but it was a useful reminder that the professionals can still get this wrong in spectacular ways.

What all of this means for the private investor is fairly simple. You are not going to beat a well resourced hedge fund to the data. You are not going to get the call from the expert network. You will never see the satellite photograph of the car park. What you can do is read their published short notes when they appear, take them seriously enough to examine the evidence, and recognise that the sharpest minds in the market are often the ones betting the other way from the consensus. If a short seller has done the work and you find yourself instinctively dismissing it because you own the stock, that is usually the moment to slow down rather than speed up.

This post is drawn from The Street-Smart Trader by Ian Lyall. Republished with permission.

Street Smart is a series drawn from first hand experience of the City of London, updated as each new chapter arrives.

Disclaimer: The value of investments can go down as well as up, and you may get back less than you invest. This article is for informational and educational purposes only and does not constitute financial advice. Always do your own research and consider seeking independent advice before making any investment decision.

This article is for informational purposes only and does not constitute financial advice. Investment values can go down as well as up. Always do your own research before making any financial decisions.