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How a Hedge Fund Can Use Insider Information Legally

CNBC – The government is convinced that money managers who consistently beat the market are probably using insider information to produce these abnormal returns. Unfortunately for prosecutors who want to shut this kind of thing down, one way this is done is perfectly legal.

One of the ways for a hedge fund manager to beat the market is to avoid buying stocks ahead of bad news about a company. You can beat the market with a diversified portfolio that avoids buying stocks in companies that underperform.

That’s hard to do unless you have a way of figuring out bad news ahead of the rest of the market. Obtaining material, nonpublic information is one way. But if you trade with this information, you risk violating insider trading prohibitions. Hefty fines and jail time won’t help you outperform.

So the way to do this is to avoid trading in the companies that are going to announce bad news. Let’s say you have a portfolio that regularly buys and sells a diversified portfolio of equities throughout the year. In that case, by obtaining inside information and avoiding buying the stocks with hidden bad news, you would avoid suffering some of the losses that would hit the broader markets.

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