Hedge Funds Under Investigation

May 11th, 2017 by

If you had to pick a field as an exemplar traditionally known for its ethical behavior, money managers (the groups that run hedge funds) are probably not your best choice.

However, hedge funds are facing a much more existential threat: Since the financial crisis, hedge funds have had a difficult time outperforming “the market”—i.e. passively investing in an entire index, like the S&P 500—and have failed to do so far more often than not.

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Bottom line: Their own bottom lines are actually beginning to hurt as frustrated investors put their money elsewhere.

Inflated Prices, Illiquid Securities

2016 was actually the first time since the financial meltdown that the amount of investor money in hedge funds declined year-on-year (by $70 billion last year). We’ll get to the ethical problem in a moment; but there’s no denying that lost profits are surely the gravest problem a hedge fund worth its salt could imagine facing.

To cite one prominent opinion on the matter, President Trump has consistently in the past criticized “hedge-fund guys” for “getting away with murder,” unduly enriching themselves beyond the average person’s wildest dreams by merely moving paper and numbers around. The implication is that they don’t create anything of real value like, for instance, extracting a resource out of the ground, or for that matter building a public park or developing some other piece of real estate (to choose an example from Trump’s relevant experience).

The federal probe into hedge funds examines whether or not these investment firms purposely lied and inflated the value of their securities—in this case, securitized debt: bonds—to fraudulently improve the fund’s performance. Bloomberg News explains:

“By carrying securities on their books at artificially inflated prices, hedge funds can show better performance. They can collect more in management and performance fees — or hide poor performance for certain holdings.”

Such bogus and inflated bids (or quotes) for these bonds held by the fund makes its returns look better. This, of course, translates into big compensation for the fund managers themselves, but also the shareholders. Beyond the lack of ethics involved in simply lying about prices, these bonds are in certain ways illiquid assets otherwise! In reality, the inflated “bid” a trader might be quoted doesn’t reflect what that bond is actually worth: what another person is willing to pay for it now, not under some fictional ideal circumstance or market condition. oftentimes, its real price tag is closer to half the published value.

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Bloomberg‘s Matt Levine has frequently covered this topic in the past in his “Money Stuff” column. Liquidity on the bond market is a constant concern, so it should be a bit alarming that a big portion of what is portrayed as low-risk bonds is actually (almost) unsellable and should be priced far lower! Levine makes a great point that a lot of this ostensibly unethical behavior is actually in line with legal practices by banks and firms in big finance.

“So many of these scandals are hard to describe in objective terms. The Libor scandal was about submitting fake numbers in Libor surveys, but even non-scandalous Libor submissions were pretty fake,” Levine writes, “so the only way to distinguish the bad fakes from the good ones was by finding chat messages” that offered clues that traders were colluding or violating clients’ trust. Establishing intent and parsing informal correspondence is not only challenging and time-consuming for prosecutors, but it’s unfortunately about the only compelling evidence that juries (and the relevant laws) are concerned with. Regulators and even the firms themselves are belatedly taking notice. Several headlines last week touted something akin to the line, “These 5 Words Cost a Trader His Job.”

Industry of Manipulation?

It is similarly difficult to pin down irrefutable evidence of market manipulation when the culprits engage in spoofing, or temporarily goosing a certain price (like gold) or rate (like Libor) in order to shake out the positions of other market participants, allowing the “spoofers” to then pocket huge profits by positioning themselves on the right side of the trade ahead of time.

In short, they place fake orders that trigger other buying and selling, only to cancel those orders with the lightning quickness of the Internet. When combined with the means to trade huge volumes, such trading activity gives spoofing firms a huge advantage. Thus, everybody who can employ this strategy probably is.

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Spoofing is seen across the most critical components of the financial system. Whether it’s forex rates, Libor or another interest rate, or the price of an asset like a bond or the precious metals, the general attitude and mode of operation for Wall St is the same: Rig it! It is only because some of these cases involve far clearer and more brazen coordination between traders in their chat logs that prosecutors have been able to move forward at all.

Mr. Levine has also covered the spoofing problem with some rather insightful sarcasm, but rarely is a firm or even individual punished or held accountable. Of course, doing so through the courts is a cumbersome business as it is. Wall St has a pervasive problem of using spoofing as its preferred tactic when profits must be manufactured.

If the past can serve as any kind of guide, expect nothing more than scapegoating and fines from the Justice Department in these cases.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.