Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
The most significant risk to any money management firm is imprudent or unlawful portfolio management. The purported stars of the system, portfolio managers often go unsupervised and un-monitored so long as they deliver results. Many firms completely ignore independent supervision either because they fear the portfolio management talent will move to another firm or because they don’t have an adequate risk management culture and infrastructure. The most significant modern case is the Amaranth debacle, where a PM in western Canada, working away from the Greenwich home office, made a crazy bet on natural gas that ultimately unwound the $6 Billion firm. In fact, portfolio manager self-dealing highlighted the market-timing scandal that led to the compliance rules for advisers and funds. As a Chief Compliance Officer outsourcing firm, we frequently implore industry players to introduce some form of portfolio monitoring. Some larger firms have implemented commercially-available, IT-based pre-trade compliance systems. Smaller firms can require that a second person sign off on every trade. All firms should also implement some measure of post-trade portfolio analysis. As the C-suite and compli-pros consider their PM risks, we offer 10 types of portfolio management misdeeds that deserve attention.
10 Portfolio Management Risks
- Internal Risk Limits. A mutual fund manager ignored internal risk limits and disclosed hedging practices. The fund lost 20% of its value, and the manager agreed to pay over $10 Million to settle charges.
- Regulatory Limitations. A large fund manager exceeded Investment Company Act limitations on fund-of-funds investing, resulting in fines and millions in investor reimbursement.
- Self-Dealing. The portfolio manager of a registered fund engaged in a matched trade scheme that allowed him to generate $1.95 Million in profits at the fund’s expense. The SEC charged that the PM matched call options bought/sold from his personal brokerage account against matching options bought/sold by the fund in less liquid securities with relatively wide spreads.
- Valuation. A hedge fund over-relied on the discretion of traders to value Level 3 mortgage-backed securities rather than use required observable market inputs, which allowed maximum profits upon sale. The SEC fined the firm $5 Million, and its Chief Investment Officer another $250,000, for failing to supervise and implement compliance procedures.
- Derivatives. A portfolio manager, whose compensation was directly tied to fund performance, used a discretionary valuation model for certain swaps and swaptions, which scheme inflated stated performance and his compensation. Within 16 months after discovery of the mispricing, the firm reimbursed clients, shut down what had been a $375 Million fund, and ceased operations.
- Currency Bets. The principal of a hedge fund used margin borrowing to make the wrong bet on the direction of the Swiss currency, blowing up the fund and costing over $3 Million in penalties and interest.
- Cross-Trades. A mutual fund portfolio manager unlawfully interpositioned a friendly broker to execute cross-trades between clients in a scheme that benefited buying clients over selling clients. The SEC fined the fund company $1 Million and ordered $1.095 Million in reimbursement.
- Affiliated Transactions. An adviser caused the fund he managed to purchase a portfolio company from an affiliated fund in violation of the purchasing fund’s debt and concentration limits. He was barred from the industry and agreed to pay over $1.1 Million in disgorgement and penalties.
- Broker Quotes. Two portfolio managers at a hedge fund firm overrode prices by obtaining sham quotes from “friendly” third party brokers. The firm agreed to pay over $10 Million in fines, disgorgement and interest.
- Trading Away. Portfolio managers in a wrap program stepped out trades to non-participating brokers, thereby costing clients additional trading costs outside the wrap fee. The SEC fined the wrap sponsor for its insufficient supervision policies.