More hedge fund fudging

BlueBay Asset Management is a “leading specialist manager of fixed income credit” for “institutional” investors, based on London.

According to an article in the Financial Times yesterday, the former manager of the firm’s emerging markets fund (since shut down) has been disciplined for deliberately misstating the price of securities in his portfolio during the summer and fall of 2008.  Apparently, the manager got prices from one or more of his brokers, went into his office, altered the figures to provide a more favorable picture, and passed the “enhanced” numbers to his back office for processing.  According to the FT he then lied to regulators when they came to investigate.

The penalty for doing this?–a lifetime ban from the investment management industry and a fine of £$200,000 (less a 30% discount for prompt payment).

Does this episode sound as weird to you as it does to me?  How so?

1.  In dealing with a long-only manager, standard procedure for institutions is to have a custodian for their funds who’s separate from the asset manager and who prices and reports performance directly to the client.  It sounds like this didn’t happen here.

Maybe this preserves the hedge fund mystique.  It certainly prevents the client from seeing that the high-fee manager and the conventional one may have basically the same holdings, and in the same proportions.

2.  What kind of institution would allow this?  Maybe, BlueBay has a very broad idea of what an “institution” is, since this not getting independent pricing sounds more like the behavior of an inexperienced high net worth individual.

2.  Who prices internally any more?  Twenty-five years ago, it was common in the US for smaller asset management companies to price portfolios themselves.  But the junk bond crisis of the late Eighties brought home that the potential liability from doing this with illiquid assets was too great.  Yes, asset managers still run their own pricing, but as a check on the official pricing done by the custodian or third-party pricing service.

3.  No sane portfolio manager wants to be a key element in the process of pricing his own portfolio.  There’s no upside.  The only thing that can happen is bad–questions after the fact about the accuracy of the pricing.  It doesn’t matter whether the prices are alleged to be too high or two low.  Someone buying the portfolio is disadvantaged in the first case, a seller in the second.

It’s true that third parties don’t always do a stellar pricing job.  I had a custodian once (a famous firm on the East Coast of the US) who kept mixing up Malaysian ringgit and Singapore dollars.  Depending on which currency they would input for my Singapore holdings, the value could swing by 50% from day to day.  The firm was also not very good at first in accounting for Asian stock splits.  But the reconciliation of the manager’s records with the custodians will find and fix problems like this.  And over the years pricing services, at least for equities, have gotten a lot better.

4.  The Financial Services Authority, the SEC of the UK, took no action against BlueBay itself.  I find this strange, too.  Maybe the practice of having the manager price his own fund is acceptable in the UK.  It may well have been permissable in the US at one time.  But it hasn’t been for at least twenty years.  I think in New York the firm would be found negligent for failing to have even elementary, easy-to-implement procedures–like having the trading desk or the back office get the price quotes directly–to avoid this conflict of interest.

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