The demise of hedge fund investment pools

I’ve been watching the demise of hedge funds over the past few years with what one might call a morbid mix of horror and fascination at the potent mix of marketing savvy, personal arrogance, snake oil and stunning technical incompetence the principals involved have displayed.

…and then there’s State Street

The case of State Street and its Limited Duration Bond Fund is an odd one.   The fund was sold as the equivalent of a money market fund, but ended up making speculative investments (which it misled investors about) using large amounts of leverage. It lost 80% of its value in the last twelve months it was in operation.

State Street recently settled SEC and State of Massachusetts charges by paying fines and reimbursing investors.

It’s rare in today’s world to see a large company, particularly one that projects an image of all-American values and stodgy reliability, to show itself to have no internal moral/ethical compass–nor, it would seem, either a compliance department or any deep knowledge of securities laws.  Also, no one seems to care.

The New York Times article

I first read about State Street’s settlement with the SEC and the state of Massachusetts in an article in the New York Times, titled “State Street Gave Some of Its Clients Better Data.” Huh?  Maybe its reporter/reader fatigue.  Maybe the blowup of a sub-prime mortgage investment pool isn’t news any more.  Maybe a disaster has to be big enough to bankrupt a company–which this wasn’t–to get any attention.

I find three things surprising:

–top management either had no clue about what was going on in the investment management business, or turned a blind eye;

–no one involved in the affair–no portfolio managers, compliance people, supervisors, marketers…stood up at any point and said “What we’re doing is wrong.” (you’ll see what I mean if you read the details below); and

–State Street got a slap on the wrist, and nothing more, from the regulators.

Here’s the story:

..or at least my summary version of it.  (You can get the full details from the State of Massachusetts consent order or the SEC “cease and desist” order.)

1. In 2002 State Street began offering the Limited Duration Bond Fund to institutional investors as an “enhanced cash fund.”  The marketing pitch was that it had all the safety of a money market fund, but with higher returns.  It could do this because it was investing in short-term asset-backed securities and some derivative instruments.  The fund might have some day-to-day volatility.  But it would remain widely diversified, more so than the typical money market fund, would restrict itself to high-quality credits and would use only “modest” leverage, if any, to achieve its goals.

(The idea of a “free lunch” is probably as old as investing itself.  People love it.  Invariably, I think, the investment strategy is based on a market anomaly that gradually disappears.  Then the concept blows up.)

As time passed, the fund increased its exposure to sub-prime mortgages, apparently figuring this was the only way it could generate yield. By the end of 2006, sub-prime had become the majority of the fund’s investments.

Shareholders, however, continued to be informed that the fund was widely diversified and involved only with high-quality credits.

(Where were the compliance people, the internal regulators who are supposed to make sure something like this can’t happen?  How could any responsible person sign the letters to shareholders?)

2. In 2005, State Street changed the way it disclosed portfolio contents to clients.  Previously it had shown the amount of leverage employed by having the portfolio contents add up to a number higher than 100%.  So if the portfolio was 115% invested, for example, that would mean that its market exposure was equal to 115% of the assets under management.  The extra 15% would be achieved through option-like derivatives.

From that point on, however, it showed the funds weightings only as a percent of the total market exposure, without reporting the amount of leverage in the fund.  All investors saw was market exposures adding to 100%.

According to the SEC, by 2007 the fund was no longer using “modest” leverage.  Routinely, 150%+ of assets were invested in sub-prime mortgages.  The new reporting format meant investors couldn’t see this change.

(Compliance?  Management?  who doesn’t see the red flag? could the change to less disclosure have merely been a coincidence?)

3. At some point, State Street decided to allow other internal finds to invest up to 25% of their assets in Limited Duration.  Through contact with the common trading room, membership on the firm’s investment committee and special detailed in-house reports not made available to outside clients, these internal customers learned the true situation with Limited Duration.  As a result, a number withdrew their funds during the summer of 2007.

State Street did not tell outsiders that insiders were selling.   Instead, it continued to assure them that nothing was wrong.  At no time, however, did it reveal the extent of the fund’s sub-prime holdings or its high leverage.  In fact, some external client contact agents told regulators that they were unaware there was any sub-prime exposure.

In one case where an external client withdrew money and then sued, State Street blamed the client for creating the losses by panicking out of the fund at the wrong time!

(Being a fiduciary means taking care of your client before you take care of yourself.  New concept for State Street.)

4. To add insult to injury, when State Street withdrew its internal money, Limited Duration portfolio managers used the most liquid securities to pay them–leaving the least liquid assets for the trusting outside customers.

(Maybe they had no choice, although the SEC says the investment committee discussed how to raise cash to meet anticipated redemptions.  Normally, a portfolio manager works first on selling the least attractive, less liquid assets.  This is partly because selling may take longer, but it’s mostly to avoid the outcome of being stuck with only unsaleable assets in the portfolio.)