Archive for May, 2009
Active or passive? I’ve seen little evidence of “passive” in any strategy. Active investing is the only choice in the REAL world since “passive” requires active decisions as to which stocks to include in an index, the chosen equities come and go and what constitutes “long term” gets shorter all the time anyway. It is also an ACTIVE decision as to which “passive” index to track. Contrary to expert opinions, “passive” investing is VERY expensive for investors since there is no risk management, no hedging or any attempt at capital preservation.
Now with absolute return strategies, no risk averse investor needs to leave their wealth in harm’s way HOPING for a bull market in the “long haul”. “Passive” funds are too volatile for conservative investors like me with a very low risk tolerance. Quasi-active “index” funds market themselves as passive because it sells, backed up by noxious “Nobel” economics nonsense. Those salesman naturally fail to point out that passive funds’ risk-adjusted performance has been abysmal even during bull markets. The massive drawdowns and high volatility of “passive” and closet “passive” index funds are a disgrace. Long only is wrong only.
Alpha is partly about knowing WHEN and HOW to change your beta exposures. Stagflation, volatility and uncertainty mean portfolio management will require ACTIVELY searching for ACTIVE investment strategies able to make absolute returns in such times. Navigating the FUTURE financial landscape will depend on finding optimal ways to analyze data, deploy capital and hedge away systemic risk. We CANNOT depend on beta anymore so it is alpha we need for RELIABLE performance. There aren’t many “sizeable rate cuts” remaining when interest rates are already so low.
To reduce risk and long only equity speculation it is necessary to move beyond asset allocation. How different strategies are combined and applied to asset classes is what matters. The active versus passive “debate” comes down to whether to hire professional portfolio managers to pick stocks or have index constructors pick stocks. It is all stock picking in the end. “Active” ETFs just got authorised which is interesting considering that non-passive ETFs have been around for over 15 years. Plus ça change, plus c’est la même chose…there’s nothing remotely “passive” about the S&P 500, Nikkei or FTSE.
The credit crisis malaise continues and will NOT be over soon. Those hedge funds that already bought distressed assets have yet find out that vulture investing works best when the carcass has been dead for a while. The Fed could reduce rates to zero today but it won’t have much effect on the depth and longevity of the bear market. The latest problems to emerge are in auction-rate securities and the VRDO market where investors were not made sufficiently aware that buying these “safe” things effectively meant being short liquidity and exposed to the credit risk of the bonds’ insurers. The “extra” yield was not high enough to compensate for the liquidity trap. That’s the trouble with auctions – buyers need to show up.
Warren Buffett has been a successful hedge fund manager for decades and recently spotted an opportunity to try to make some money reinsuring the municipal bonds insured by MBIA MBI, Ambac ABK and FGIC partly owned by PMI and BX. It is unlikely the offer will be taken up and it does not change the dire outlook for those firms’ exposure to structured credit and CDO toxic waste. The stock market is STILL not recognizing the growing problems in the CLO, CDS and LBO debt markets either. How many “secured” loans were genuinely secured? How much “security” was there in securitization? Asset-backed securities need the underlying assets to be somewhere close to their ASSUMED value.
Buffett’s offer may sound like a positive development but it is a negative for the monoline insurers. It just signals his interest in stepping in should those firms go under or get split up due to their more exotic liabilities. Out of crisis there is always opportunity and he has been generating alpha out of special situations and distressed credit for a long time. Buying and holding large value stocks is just ONE strategy within Warren’s multistrategy hedge fund.
This is not the end of the credit crisis. High credit correlation implies more volatility going forward. The stock market seems to be ignoring the chaos in the leveraged loan markets. The Blackstone BX led Alliance Data Systems ADS problems grow but that is just the canary in the coal mine for other deals. Probably the most seemingly sensible large private equity LBO last year was the Harrahs HET acquisition. On the left side of the Vegas strip after the Venetian there are several older casinos in prime locations all owned by Harrahs and all of which would best be demolished and replaced with a modern mega resort. Harrahs needed to go private for a few years and eliminate quarterly earnings scrutiny as it forgoes gaming revenue from those properties and rebuilds for the future. That a strong LBO with a solid business case could not raise sufficient debt shows how bad things are.
Elsewhere in the markets, Microsoft MSFT would like to buy Yahoo YHOO. Both ARE great companies but WERE good stocks once. I doubt Google GOOG lost much sleep other than brainstorming deal delaying tactics; its search technology is superior and its “new” competition will take years to integrate their cultures. Industry and product lifecycles are born and die fast these days. Companies, just like investment strategies, have short half-lives and depend on ongoing innovation to keep performing.
Several years ago when AOL was added to the S&P 500 I used the opportunity to get heavily short, selling to the index trackers yet every broker I gave the order to said I was crazy as it was “obvious” AOL was going to “own” the internet and their analyst rated it a “strong buy”. It turned out to be almost exactly the top and AOL did not end up controlling the web. There can be no buy and hold when the commercial and technological environment changes so quickly. Today’s no brainer buy can be tomorrow’s short sell.
Google is more likely worrying about tiny startups like some of the venture-backed new search technologies I saw last week, not Microsoft-Yahoo. Otherwise in 2018 people might be asking what was the name of that stock investors got so excited about back in the 00s? Goggle.com or was it Googol.com? When was the last time you searched on Excite or Altavista? Both were major players not so long ago. Netscape was once the hottest stock around. Ten years from now we will probably have trouble remembering that Facebook ever existed. It’s so popular no-one goes there anymore! Facebook fatigue shows yet again how social networks are a very fickle business. Anyone still remember Myspace.com?
Investors CANNOT be passive when the investment opportunity set is so active. Buy a stock because it is in an index OR because it has good value and FUTURE business growth prospects? The Dow Jones Industrial Index just made the ACTIVE investment decision to bet on Bank of America BAC and Chevron CVX. The Dow is supposed to be representative of the broader US economy and banking and energy already had a fair weighting. It is often better to keep your winners so dumping last year’s highest returning Honeywell HON seems a tad harsh. Altria MO has been the best Dow performer over several decades. Sad to see the traders that construct the Dow Jones suffer from the disposition effect and make the DISCRETIONARY decision to sell winners but keep some losers.
If HON and MO must go then I would have added Berkshire Hathaway and Google as both bring more diversification to the mega cap index. Dow Jones would probably argue that BRKA is too illiquid and GOOG too “new” but the real reason is that with the absurdity of price weighted indices GOOG would have comprised 27% while BRKA would be over 99% of the Dow at current prices! How silly to limit the world’s best known market metric to only those stocks that agree to stock splits. Surely market capitalization or another fundamental metric would be more appropriate. And why should illiquidity be an exclusion criterion for what is supposed to be a long term benchmark?
There is a notion that equity indices are passive when each addition and subtraction is an active choice. I have very accurate point in time and dividend data going back to 1896 and just spent my time in Alaskan airspace looking at the Dow Industrial’s worst ever TRADES. The forerunner of Chevron first got added back in 1924 and it might have been better to leave it alone. Back in the 1930s the Dow added Coca Cola KO and IBM, deleted them a few years later and then re-added them after MISSING several decades of exponential growth. If those two stocks had been in the DJIA throughout, as best I can figure, the Dow would be somewhere around 26,000 today.
But can you blame the Dow for deleting such obvious “losers” at the time? Selling overly sugared soda made from a black box recipe during the depression? Manufacturing international business machines when the future CEO estimates market demand for five computers and most of “international” are preparing for war? Not very persuasive business models at the time. Conversely it is not so long since “blue chips” like Bethlehem Steel and Woolworths FL were in the Dow and we know what happened to them. Long/short means buying good stocks and shorting bad stocks; is that so dangerous? Is long only really “safer” than long/short?
I would have thought that prudent investing would require funds to be managed by full time stock pickers with NO other duties. I am sure Marcus Brauchli is a fine managing editor at the Wall Street Journal but how does that afford him time for intensive equity research? The recent changes in the Dow do NOT “fully reflect the market”. Are BAC and CVX really better additions than BRKA and GOOG? I realise MO is basically a stub now but Honeywell are right to be miffed just like the bizaare dropping of International Paper IP last time. And is Cisco CSCO really “less” deserving to be in the index than American Express AXP? Far more money tracks the S&P and Russell but the index followed by most people is the DJIA so it ought be as representative as possible given its influence on sentiment and media headlines.
Even that Dow bellwether General Electric GE has been traded before. Whether it is the Dow, S&P, FTSE, Nikkei, Hang Seng they are all managed ACTIVELY, mostly by newspaper publishers. There is no “passive” as index components go bankrupt, fall by the wayside or get bought out and then a trading decision must be made as to what the replacement will be. As equity market barometers these indices have use to measure alpha production by managers but to actually invest in them? Index reconstitutions have long provided profitable pairs trades for those nimble enough to put them on. Who would have thought that beta players handing alpha over so easily? Stock picking is best left to those with an informational edge and vocation in doing that stock picking. Even in the best of times there are plenty of stocks that go down.
Since we live in an active world the only style that really exists is ACTIVE investing. It may be the decades outlook of Warren Buffett or the seconds of a high frequency statistical arbitrage trading strategy but regardless of holding period it is all active decision making. Equity indices that are quasi-passive are those that minimize stock picking discretion. The Nasdaq and TOPIX include EVERY stock on their respective exchanges; they are still active though since the equities change. Check out the Nasdaq components today compared to 2000. Lots of ACTIVE natural selection there driven by business success and failure.
Whether an equity index will go up is conjecture. That some stocks go up and others go down is a CERTAINTY. Given that active investing is the sole choice available it would seem to be the best course of action is to hire the managers with the most dedication, skill, talent and incentives to figure out which stocks to buy and which to short and REDUCE risk as much as possible. Economic conditions, products, consumer trends, corporate and human longevity and geopolitics changed rapidly last century and will even more so in this one. How can passive succeed in such an active environment?
Hedge funds outperformed in January and 35% made money unlike all the “passive” indices that lost $5 trillion of investors’ hard earned cash. I don’t know where people get the idea that January was “difficult and challenging” when it offered so much opportunity and volatility. Often missed by some about short selling is that as the price moves down you need to do more short selling just to maintain the same portfolio percentage weighting. Stock indices might or might not go up but many more individual stocks drop to zero than go to infinity. I wrote in early December how “short only” was probably going to be “the” strategy for 2008 though I reserve the right to change my mind. The only way to survive in finance is to adapt to the CURRENT and forward looking scenario.
There is no inherently reliable return from “stocks” OR “real estate” anymore than “hedge funds”. Even dividends and rental incomes are pretty unstable. It is naive at best, dangerous at worst, to “expect” to be compensated with risk premium. So next time your real estate broker tells you houses “always” eventually hold their value or your stock broker/wealth manager/private banker/finance professor asserts that stocks “must” go up over very long holding periods, tell them to write you a 30 year at the money put option on any index of their choice, Dow, Dax, Shanghai Composite, BSE Sensex…whatever. For zero premium. Risky assets “will” go up therefore in their mind there “should” be no chance of the option expiring in the money. If they refuse ask them the reason for their caution.
If you were an animal, what animal would you be? As far as finding good fund managers is concerned, look for an alpha rat. Now it is the new year, why does the twelve year animal cycle in Chinese astrology BEGIN with the rat? Because the alpha rat was smart, small and nimble enough to win the race against the lumbering beta buffalo, goat, horse and others. A bona fide hedge fund manager is an investment rat; able to survive conditions that destroy others, exploit crevices of opportunity amid adversity and outperforming the slower financial fauna. They are often hated by others for their very existence or wrongly blamed for incubating any financial disease that hits the markets.
The investment jungle is still mostly inhabited with soon to be extinct beta brontosauruses strutting around unwilling or unable to do the dirty, hard work of seeking alpha. Rats figure it out earlier than most and take protective hedging action as soon as danger appears. Remember the rat scene after Titanic hits the iceberg in the movie. Military strategy says to advance or retreat; take risk aversion action because passively hoping things will turn out alright usually ends with defeat or worse.
Whether credit and recession strike the market and whatever the economic scenario there is ONLY active investing. Markets change so portfolios must adapt to them. It is staying agile and innovative and keeping up with new opportunities that sorts the alphas from the betas. Markets morph, factors fluctuate and drivers deviate. As in any industry, the passive become obsolete while the active thrive.
Time is not money; technology is money. The way to predict the future is to invest in it. The only certainty is change. Technology is affecting how we manage money and innovation impacts everything. Good hedge funds are disrupting the clubby, risky long only world. Successful investing REQUIRES flexibility so it makes sense to keep up with the trends. NEW strategies and financial products have changed OLD investment strategies. The coming bear market will finish off strategies incapable of adapting to the different economic scenario going forward.
Creative destruction doesn’t only apply to business innovation it also applies to investment innovation. There has been plenty of Darwinian natural selection in fund performance and survival of the fittest recently. Past returns are not predictive for future returns and market evolution means reliance on HISTORICAL assumptions is NOT applicable going forward. Investment technology benefits people just like other technologies so why ignore NEW things and hope to rely on the OLD ways?
The World Economic Forum coverage in Davos was subdued this year but then the REAL action was elsewhere. Hedge fund managers were at their desks with no time to head for the Alps when there were mountainous trading opportunities and valleys of risks to negotiate. Sometimes the World Economic Forum yields an end-of-party short sale signal like private equity in 2007 or dot.com stocks in 2000 but no irrational exuberance this time. I was hoping there would be another “obvious, no-brainer, definitely going up, can’t lose” meme so I could short sell it.
Monetary policy should also take account of how globalization and capital flows have CHANGED the economic game. Economics is about maximizing the use of scarce resources and that includes how best to put money and intellectual property to work. The optimal utilization and protection investors’ of capital are key to maintaining economic well-being. People respond to economic incentives. Performance fees INCENTIVIZE good fund managers to do a good job, work to MINIMIZE losses and control risks. High compensation attracts the best financial people to set up and join the best investment firms. Responsible investing requires having the most skilled portfolio managers and traders taking care of your money. The 2 and 20 versus 0.20 fee debate is an example of how incentives lead to better products that more closely match INVESTOR needs. Index funds and “cheap” long only funds cost investors TOO much in bear markets.
More information, lower trading costs, more liquidity, more computer power, new geographies, asset classes and financial products have enabled proper diversification. One reason buy and hold looked good in the PAST, although quite poor on a risk-adjusted basis, is that in earlier decades the costs of trading and information gathering were high. There wasn’t much else to invest in other than long only but the range of opportunities TODAY is much broader. Long term performance is MUCH more important than long term holding periods. Some stock indices WENT up but WILL they now that financial markets are so different?
Formerly, many informational edges could not exceed the trading costs involved in executing the strategy but NOW they can. Commissions are lower, higher trading volumes mean less slippage and competition from national and global market deregulation have benefited ALL investors. Data gathering using machines with superior information processing capabilities have helped their human masters make and execute investment decisions. Financial innovation in the form of derivatives, structured products and hybrid securities allows risks to be sliced, diced and hedged as required. New strategies and assets have let investors FORTUNATE to be permitted to use them to get more diversified.
These benefits come with complexity which creates the need for “expensive” expertise in trading and managing these risks. Derivatives are useful trading and hedging vehicles OR weapons of financial destruction DEPENDING on the competence of those using them. Osaka rice futures and Chicago soybean futures have allowed farmers to transfer risk for generations AND built many traders’ fortunes but have also wiped out many more unskilled speculators. Equity, interest rate and credit derivatives have been hugely beneficial to end users and competent investors but do damage if used wrongly. Fire has been very important to human economic development but fire in the wrong hands can be disastrous. We still need fire though.
Societe Generale’s derivatives trader Jérôme Kerviel played with fire and lost $7 billion. I wonder if it would have been revealed if his rogue dealings had brought in $7 billion PROFIT? Curious how heavily regulated banks seem more prone to rogue traders than “unregulated” hedge funds. When it is your OWN money and own firm’s reputation at risk you are more likely to catch unauthorized trading by the troops or question numbers that are out of line with margin limits. There have been a few hedge fund frauds although the premier meltdowns like LTCM, Amaranth, Bear Stearns were due to inexperience and lack of skill NOT rogue traders. You can’t eliminate the possibility of losses but with proper due diligence and monitoring you CAN eliminate the risk of fraud AND incompetence in hedge funds.
I’ve written several posts about LBOs and CDOs but the products themselves are not to blame for losses anymore than credit derivatives. LBOs, pioneered by KKR, were a brilliant financial innovation. The issues that bothered me in recent years was their dependence on cooperative credit buyers, the strategy NOW being too well-known and too much money in the “taking public firms private” arbitrage trade. Similarly CDOs are a great invention but it was executive arrogance, junk math, dubious pricing, mad modeling and ridiculous risk management that were the problems NOT the idea behind the products themselves.
The credit crisis is one factor that has led to the present economic situation. It looks like we are going to get some kind of stimulus package though whether it will be the catalyst for the necessary change in sentiment is anyone’s guess. Rate cuts help banks with steeper positive carry, assuming credit worthy clients still exist and want to borrow, but the primary idea is that low rates spur spending and investors to move into riskier assets.
The possible flaw with this economic antidote is that when real estate and credit markets are performing even worse than stock markets then risk aversion can INCREASE. If your 401(k) statement shows a much lower number than the previous one and that house nearby just heavily reduced its asking price, a money market yield of 2% can START to look attractive compared with heading to the shopping mall or buying into the “stocks are cheap” sales pitch. Stocks can get MUCH cheaper but more importantly so can real estate.
Recession or not, stock markets ANTICIPATE problems and portfolio drawdowns change the economic outlook. Bear markets are “defined” as a drop of 20% but does it matter? A 20% fall is a huge loss already and needs a 25% rally just to get back to breakeven. So whatever economic scenario transpires, a fall of that magnitude for long only equity portfolios is not only unacceptable but also unnecessary. The appropriate use of hedging instruments and new investment strategies ought to have made such portfolio volatility obsolete by now.
Whether we are in a bear market or a recession is just semantic debate. Traditional equity, credit and real estate investors HAVE lost money and that WILL change behavior. The Fed has been criticised for “panicking” last week with a 75bp cut after heavy selloffs in Asia and Europe after the Societe Generale debacle but they probably had no choice given the circumstances. If Ben Bernanke had NOT cut, the US stock market would likely have lost 7-8% that day or 1,000 points on the Dow. Such a drop in a single day would have had a very negative impact on investor psychology. Central banks try to protect the economy and stock market fluctuations have a direct and immediate effect on economic well-being.
Doubly damaging is that not only have traditional strategies failed to preserve investors’ capital but inflation is raising the cost of living. Reduced savings and less spending power are not a recipe for growth. Many analysts like to focus on a misleading metric called “core inflation” which EXCLUDES food and energy prices. So according to economists, as long as you don’t eat, don’t use any form of transportation and don’t heat your home in the winter, insidious inflation is indeed “moderate”! For those of us outside the ivory tower in the harsh cold of the real world, let’s hope stagflation is avoided. Six months ago some said credit contagion was “contained” and we know how that absurd assertion turned out.
Even if someone avoids new assets, structured products and hedge funds themselves I don’t think anyone can dispute that such disruptive technologies have impacted market dynamics. You may dislike dark pools, derivatives, decimal point price increments, deregulated commissions and day traders as well but they have changed how securities fluctuate. A buy and hold investor is affected by new strategies and trading technologies whether they want to be or not. New ways of preserving wealth are like new ways of preserving health. But just as there are quacks and charlatans in medicine, there are plenty of good doctors in HEALTHCARE and talented fund managers in WEALTHCARE.
Financial and medical technology have other parallels. There was once a time when innovative surgeons were ridiculed for their “radical” ideas of washing hands and using anaesthesia before operating. Technological innovation in HEALTH management has benefited everyone. Why then in WEALTH management do many financial advisors remain in the stone age world of
prehistoric “modern” portfolio theory? Hedge funds and derivatives are not fads and can assist in REDUCING market exposure BEFORE bad things happen. Portfolio immunization prevents economic diseases like recessions and inflation sickening investors.
“Hedge fund” is a loaded term these days so rebranding them simply as “diversifying skill-based strategies” would help. New investment technologies that seek, but do not guarantee, to produce absolute returns even if underlying asset classes fall apart. Some will deliver and many others won’t but ALL investors need strategy diversification in their portfolios. As for “derivatives”, they enable risk transfer from those that DON’T want an exposure to those that DO. Derivatives may be dangerous in the wrong hands but they are very useful and EVERY investor needs them.
Data-driven prediction and market anomaly detection are necessary for consistent returns. Systematic trading strategies like quant funds are in the news again because some weak models weren’t properly tested for bearish conditions. Maybe it would be better to rebrand quantitative investing as carbon-based organisms outsourcing the more tedious aspects of security analysis, data gathering and trade execution to silicon-based organisms. Failing to make use of robust quantitative strategies and modeling techniques is a bit like refusing to use electricity or email. And why get one of those “unecessary” computer things when slide-rules are so useful for so long? Society moves on.
Artificial intelligence complements human intelligence. Alan Turing didn’t have financial markets in mind when he did his work but computerized traders can mimic and often “think” better than many human traders, thereby satisfying the Turing Test as far as trading is concerned. It may be quite a while before computers can pass for a human in natural language processing or other endeavors but in finance the Singularity isn’t near, it’s already here.
Bear markets for stocks and credit are bull markets for alpha. There is always an OPPORTUNITY market for absolute returns. Short selling is performing well and stock indices have erased ALL last year’s gains. Investors have not received the alleged equity risk premium for so long but then stocks don’t read economics textbooks. Not many people can afford to wait decades for REALITY to catch up with dubious, unproven THEORY. The “panic of 2007″ WILL get much worse in 2008.
I can’t predict markets and prefer to identify arbitrages and anomalies but I would be very surprised if the Dow or Nikkei are still above 10,000 by the time this MAJOR crisis and deep recession are played out. Few investors can wait long enough for beta bets to pay off and why should they when they can allocate to PERFORMANCE driven managers with the RARE skill to generate absolute returns AND preserve capital no matter what the economic conditions? Even more damaging is the double impact of lower risk free rates at the same time as the stock market collapses.
The S&P 500 is now at 1,400 as it was 12 months ago AND 96 months ago(!) back in January 2000 but it could be worse; in January 1988 the Japanese Nikkei was at 24,000 and TWENTY years on the index has “grown” to 14,000. When will traditional investors belatedly realise there is NO inherent return from “the stock market”. Just sell-side stupidity and historical hype based on faulty fundamentals. With equity benchmarks mostly flat for the decade investors can be grateful for alternative sources of return that have helped properly diversify portfolios and preserve capital. A stock and bond portfolio is TOO risky for conservative investors like me. Some stocks go up but most go down. Long/short is SAFER than long only.
Strategies make money out of asset classes. In implementing a strategy the fund manager must either have a protective moat of a talent-based barrier to entry or keep it secret. Many things in the public domain do NOT work anymore but is that surprising? “Sell in May” timed the market brilliantly last year while “3rd year of Presidential cycle” didn’t but then both are just statistical flukes. The Dogs of Dow, the January effect, the “Magic formula” of value investing are too well known to work anymore. Those anomalies, among others, are gone. I hope for the sake of the long only crowd that the “First 5 days in January” is not predictive but suspect it will be this year. Buy stock index puts! NOW.
Investing and trading have important roles in portfolio management but it is NO place for gambling on the supposed “upward drift” of equity benchmarks. Prudent investing surely requires acknowledging the possibility of an extended bear market and constructing a portfolio that can grow, if necessary, no matter what happens. Inflation bites, bills come due and liabilities grow regardless of what stock and credit markets do. But “risk free” yields are far below required actuarial return targets.
What is the difference between investing, trading and gambling? With the first two it is the holding period; seconds to months is trading and years is investing. Investing and gambling are quite similar at first look; putting money at risk in the hope of making more money. Decision making under uncertainty. But most investors would balk at the idea of being called a gambler even if the markets often resemble a casino.
Surely the difference is that investing is deploying capital when you DO have the edge while gambling is when you DON’T have the edge. To make consistent absolute returns it is necessary either to have an advantage or identify someone else with one. That does not eliminate the possibility of small, manageable losses but it does mean persistent and predictable performance. By definition there is no edge in beta and it is not very reliable over most relevant time frames.
There are reasons to be bullish but then there usually are. The mythical “private equity put” and “Greenspan put” evaporated to be replaced by the sell-side delusion called “global decoupling”. Many economists are predicting a recession which, given their track record, means there is a chance there won’t be one. Several large US banks will report earnings this week and with new CEOs and new stock options the temptation to write down doubtful CDOs, SIVs, CMBSs and real estate loans to very conservative levels and adopt a kitchen sink approach to disclosing bad news must be high. LAST quarter can be blamed on former management but not the NEXT quarter. Ben Bernanke promising rate cuts was clearly preparing the market for bad news.
Monetary policy isn’t quite the economic rudder many would like to rely on. Some central banks think raising interest rates will curb inflation and lowering interest rates will avoid recession. Maybe but not necessarily anymore as global capital flows and new, non-obvious relationships between assets and geographies may have changed the rules of the game. High rates in Iceland or New Zealand or low rates in Japan or Taiwan haven’t had quite the effect that central bankers anticipated.
Situations change; western investors helped out Asian banks and now Asian investors help out Western banks. Asset classes shouldn’t be looked at in isolation as they all have varying effects on each other. Commodities move stocks, currencies impact bonds and vice versa. Last year showed how long-biased credit strategies could hurt everything from private equity LBO funding to some of the more crowded “market neutral” equity strategies.
One of the hedge funds that profited from the subprime CDO meltdown, Magnetar Capital, did NOT contribute to “astronomical” losses for the street; some counterparty banks simply didn’t know how to price or hedge structured credit tranches properly. As with caveat emptor, caveat venditor or seller beware – if a sell-side firm can’t manage the risk in a product, don’t sell it to clients in the first place. You can dress the credit crisis up with the exotica of Klio and Norma CDOs but basically it was poor quality financial engineering and fictitious capital rearing its monstrous Cetus-like head.
Casinos are now using something called NORA or Non-Obvious Relationship Awareness in their surveillance work. Successful investing is now very dependent on monitoring non-obvious relationships between securities. It was the key to doing well in 2007 and will be more so in 2008. This is where many err; looking at a single stock, pair of securities or one asset class when it is the ENTIRE interrelated macro puzzle that needs analyzing as well. Sometimes a stock, bond, commodity, currency or any other security goes up and other times it goes down. Predicting those moves is difficult but some can do it. Their changing relationships opens up anomalies and inefficiencies that can be exploited if you work hard enough to identify them.
Around New Year I spent a few days in that bastion of statistical arbitrage, Las Vegas, the only city in the world named after a volatility metric. I am always long every vega. The usual opinion on casinos is you can’t beat the house just like conventional “wisdom” in finance is that you can’t beat the market. In general that is true since the sweat equity, concentration and aptitude required to perform such a difficult task on a consistent basis is rare. Difficult yes, impossible no. Like others I’ve taken the time to try to find an edge in picking managers and picking securities. And some people have an edge in Vegas.
As in financial markets there are slight advantages that can be developed in a few casino games to change the negative expectation of gambling to the positive expectation of investing. But it requires dedication, insight and research. Many people are aware Blackjack can be beaten but disclosure of the techniques and changes in the rules have reduced that edge. The first time I visited Vegas I had mastered basic strategy and the probabilities almost as well as Ed Thorp and could memorize cards as well as Dustin Hoffman and I did reasonably well; nowadays I am content to break even. But others have greater skill and do better than that.
Despite the increased sophistication and monitoring at casinos there are still professional blackjack players making money from innovating their strategy and developing their talent. Just like a proper hedge fund keeps refining and adapting its edges and finding new ones. Perhaps even roulette and dice games can be “beaten” if beaten is defined as having a small probabilistic bias that reduces the house’s advantage; it just takes high ability AND years of practice to do it. Skeptics can read the book Eudaemonic Pie or Google “dice control” for some basic tips though what works NOW is not going to be written about or easy to implement for obvious reasons.
Poker is a game of luck over one hand but skill over many hands. And when I looked up at the casino’s sports book I saw potential mispricings and arbitrages on the board just like on a futures exchange or page of stock quotes; but it does take hard work, an informational advantage and domain knowledge of the teams, players and horses to identify them. I’ve written before that a sports gambling hedge fund would make sense although there are larger edges available in financial markets than in casinos.
Slot machines are interesting from a risk/reward perspective. The house has the edge but that does NOT imply they should never be played. The POSSIBILITY of an enormous payout for a very low capital outlay is a different value proposition. “Experts” say that the odds of hitting a +$10 million jackpot are so remote (1 in 100 million or so) as to make them a loser’s game. But as with a national or state lottery, the probability that the jackpot will be won is 1.00, i.e. a certainty. Someone WILL win it. If you don’t play you have ZERO chance of winning but if you DO play you have an unlikely but NON-ZERO chance. Since any number divided by zero is infinity the act of risking a few bucks RAISES the probability of winning by an infinite multiple! The optimal algorithm with a lottery or a Megabucks slot machine IS to play but with small cash. Similar to buying far out of money options; even if most expire worthless, you only need one to pay out.
By complete fluke I happened to put $20 into a machine one evening and won $1,000. Deducting “fees” of 5% and 50% that is a “return” of 2,400%. So now you know what the “best” performing “hedge fund” was last year – the Nevada Slots Opportunities Fund. A stupid statement of course but sadly such unrepeatable luck has been used to market many a real fund. Naturally that return was “pure alpha” as I had the “skill” to pick the right machine in the right casino at the right time. NOT. But I have seen even sillier contentions in some fund marketing materials. There will be plenty of mean reversion in certain stock markets this year.
Suppose I had then lent the $1,000 to someone who promised to pay back $2,000 if they won speculating on local real estate. What if I assigned an overly optimistic default probability to this “trade” and launched the Nevada Credit Opportunities Fund on the back of this “amazing” mark-to-model yield? Sounds ridiculous but that is what Merrill Lynch, Citigroup, Bear Stearns, Northern Rock, Sowood and Dillon Read among several others were effectively doing in their credit businesses. Subprime borrowers weren’t “obeying” the Moody’s KMV model any more than stock markets have been rewarding investors for their “risk”.
The cold winter of the real world has not been kind to the warm summer of academic conjecture. Zero passive equity index growth century-to-date! I’ll take different strategies applied to assets rather than the “reliability” of the asset classes themselves every time. That very long term security called Gold may be around $900 today but remains far below its inflation-adjusted high set nearly 600 years ago. Gold traders and gold miner pick and shovel makers – yes, long only gold – definitely not. Take the long view? On what?
What if in 2020 or 2030 major equity indices are LOWER than today? Lost year, lost decade, lost…? High yield only makes sense if it is higher than the risk. Volatility and extended drawdowns do NOT always compensate with performance. Whenever I hear the case for long term passive investing I wonder what temporal era is meant – geological or cosmological time. Over holding periods of importance to humans I’d rather invest in alpha than gamble on beta. It snowed today in Baghdad and Maui; “unlikely” events can and DO happen that risk “models” can’t handle.
Hedge fund performance ranged from -100% to +1,000% this year. A few blew up while some others bet the farm and happened to be correct. Most investors avoid short biased strategies so it is ironic that shorting credit was the best performer. In 2008 shorting equities will likely be the best strategy. Some hedge funds that shorted subprime indices and the stocks of mortgage lenders and banks were very skilled. But the performance that matters is how much money was made from how much risk in a truly DIVERSIFYING way.
The “average” return includes many funds and strategies with different levels of risk and leverage and includes such a wide dispersion of performance that it is irrelevant. Hedge fund databases list many non “hedge funds” and miss lots of good and bad actual hedge funds. Because positive results are unbounded to the upside but losses are floored at -100% the skew from the effect of high outliers will upwardly distort the mean anyway. Also there is the much bigger issue of precisely what kind of returns investors are seeking.
There are more one hit wonders in fund management than the music industry. Every year there will inevitably be traders that make a big bet on some idea which proves to be right. Whether they can keep on finding ideas that work and can hedge risk in case their next idea is wrong is much rarer. Some good funds had a flat to slightly negative year while some lucky funds had enormous returns but one year counts for little. A manager that makes +15% CAGR over 15 years is more impressive than one that makes +1,000% in 1 year.
Alpha or beta? The purpose of a hedge fund is surely to offer a source of performance NOT obtainable from a traditional fund. This would imply that the “performance” to measure is the risk-adjusted true alpha that a manager extracted from their opportunity set. The idiosyncratic returns contributed over and above what the underlying factors added. If you do this you get a very different ranking of performance results than what the headlines suggest. It is the QUALITY of the returns that matters not only the QUANTITY.
Obviously I favor hedge funds but many of the concerns critics raise on general hedge fund industry issues ARE legitimate. For asset allocation unhedged traditional funds have lower fees, lower due diligence costs and more liquidity and transparency but they do little to mitigate risk. IF a return source can be accessed through a traditional product that is the way to go. The reason to invest in ANY hedge fund is if it can produce a risk-adjusted return that would NOT have been otherwise available.
Unfortunately many products purporting to be hedge funds are dependent on the underlying asset class going up. Credit, until very recently, and currently Asian/Latin American stock markets are examples. Many energy hedge funds have ridden energy beta this year. Too often leveraged beta gets disguised as alpha. It is also easy to appear uncorrelated but be beta dependent. Many of the basic high school linear statistical measures are useless. A high volatility equity can have zero beta. A low volatility fund can have enormous risk. A low correlated fund can be 100% dependent on the underlying but conversely a fund with a correlation of 1 can STILL be a valuable diversifier!
A high volatility hedge fund can be low risk and REDUCE the volatility in a portfolio. Some of the riskiest strategies in isolation have the opposite function in that they lessen total portfolio risk. This rather nullifies the performance statistics hedge funds and funds of hedge funds email out to investors each month. Mean variance optimization isn’t very useful in hedge fund portfolio construction when averages, variances and covariances are either useless or, worse, misleading.
HOW the return was made can be more important than WHAT the return was. If you are SURE the stock market is going up next year you probably do NOT need any hedge funds in your portfolio. If you think oil, gold, Chinese real estate or anything else is going up there are better ways to implement that view than a hedge fund. But if you want exposure to the opportunities created by the mispricing and anomalies in and between asset classes, ESPECIALLY if the asset class goes down, then that is the main reason to invest in a hedge fund. Most investors already have enough exposure to economic growth and long only.
“Hedge funds” apparently outperformed “equities” in 2007. But hedge funds are supposed to offer an alternative source of return. How equities or any other asset class performs is irrelevant. Hedge funds are strategy classes. And which “equities” are we talking about? The MSCI World index is not very worldly anyway. Compared to Chinese indices “average” hedge fund returns have been pathetic; compared to Japanese indices “average” hedge fund returns have been brilliant. So what? Whether a hedge fund underperforms or outperforms any asset is of no importance; it is the DIFFERENT performance that matters.
I’ve written before that most of the -100% funds this year were not hedge funds anyway. That was clear to me years before they imploded. But non-hedge funds marketing themselves as hedge funds cuts both ways. Several of the funds that made +100% this year were also NOT hedge funds. What amounts to leveraged long only equities, commodities or other assets is not a hedge fund strategy even if there is supposedly a modicum of shorting or hedging going on. Making money when the underlying rises and losing money when the underlying falls is a closet INDEX fund not a hedge fund. Why pay hedge fund fees for performance obtainable elsewhere? No-one makes money all the time of course but losing money is better when other things in the portfolio are making money.
Emerging markets have been the best “performer” this year though comparatively few “hedge funds” operating in the space actually are hedge funds. Much of the returns have been driven by beta. If a manager can’t make money in the absence of beta then it is not a hedge fund. If you think China, India or Brazil equities are going up buy ETFs like FXI, INP and EWZ or some other long only product. There is no logical reason to pay 2 and 20. I’ve met several Indian and Brazilian funds recently and usually ask them how they would have done if the BSE or BOVESPA were down 50%. The good ones would still make money or at least preserve capital in that scenario. Not the bad ones though…
At the moment everyone loves Chinese and Indian hedge funds and hates Japan focused hedge funds. Obviously the headline absolute performance is vastly higher with many of the former up over 100% while many of the latter are up less than 10% or even negative. But if you compare their alphas as I define alpha: observed return minus expected return generated from their security universe adjusted for exposure and risk so the “performance” of a +10% Japan hedge fund could be argued to be superior to a +100% China hedge fund.
Alpha is surely what has been generated from a particular opportunity set adjusted to reflect the risks. A USA fund that makes 20% picking S&P 500 stocks has probably done a better job than a fund that makes 30% picking obscure microcaps. A Germany long short fund that produces 20% has likely done better than a Russia fund up 40%. If a fund sets up to invest in art, violins or uranium then it must demonstrate how it will STILL make money when art, violins or uranium go down. The are many “niche” strategies knocking around these days that use the hedge fund label to be trendy and charge fees more than they are worth but have little to do with hedge funds.
There have also been lots of portable alpha mandates recently. But these are only of value if it really is alpha NOT with plenty of beta mixed in. Asset allocation overlayed with strategy allocation is impossible if it just adds more beta to the portfolio INSTEAD of adding alpha. Strategy allocation should be about strategies that can perform when long only does not.
In the hedge fund oasis of Dubai again. I bought some Dirhams at Citibank and then spent most of them down the road in Abu Dhabi. I was going to exchange the balance to US$ until I came to my senses and purchased some more – why does the United Arab Emirates STILL have a dollar peg? There has also been an ongoing debate on the “high” cost of funding that Citigroup raised from the Abu Dhabi Investment Authority.
The chart below shows the payoff of the Citi FORWARD sale of equity to ADIA, yield enhanced with an embedded options spread. It was NOT at junk rates.
The termsheet reveals a fairly plain vanilla mandatory convertible. But pundits said that Citibank paid MUCH higher than junk bond yields. This nicely illustrates how differences of opinion on the valuation of hybrid debt/equity financings and some people not even noticing embedded options are opportunities for alpha. The level of borrowing cost was surprisingly LOW for a bank facing major problems. Probably it was too cheap capital.
Financial engineering, model arbitrage and misunderstanding of what a sophisticated security really represents allow skilled investors to make money out of the unskilled. The fact that so many jumped on the “junk” 11% headline is a lesson in itself. That they missed the options is another. Subprime CDOs also paid a “high” yield but most buyers didn’t realise or were not informed(!) about the credit default options they were implicitly SHORT SELLING, much too cheaply.
The structure looks like Citi purchased the right to put stock to ADIA at 31.83 and sold a 17% out-of-the money call so ADIA would participate in any upside above 37.24. Since large bank equity puts are massively bid by those seeking protection and therefore implied volatility is high, ADIA picks up plenty of skew by writing the at-the-money put and buying a higher strike call so was obviously owed SUBSTANTIAL premium on the collar. So the “shocking” 11% coupon is explained as compensation for ADIA forgoing the 7% dividend yield available from Citi common, the high embedded option spread that Citi bought from ADIA, the typical equity premium on a mandatory CB and the tax treatment. There are also other terms in the deal that offer Abu Dhabi some protective rights WHEN the stock goes much further down.
The 11% coupon convertible to a 4.9% stake were EXACTLY the same terms offered in the convertible preferred bought by Prince al Waleed bin Talal al Saud the last time Citi got itself into trouble. The credit cycle repeats but lessons are NOT learnt; SIVs and CDOs now, real estate loans and broken LBO debt in early 1990s(!), and subprime countries don’t go bust(!) in early 1980s. Over 30 years nothing has changed with Citigroup’s continued misunderstanding of credit risk.
Since billions and trillions get confusing, suppose an investor with a $90,000 portfolio decided to risk $750 on a major bank in distress and whose stock was far below its high. I don’t think anyone would see that as particularly risky. ADIA has about 0.8% of its portfolio in the trade. Even
when if Citi stock goes to zero it will NOT be a disaster for the ADIA. Abu Dhabi has written a put at a level they would presumably be content to own the stock and get paid a dividend plus the embedded option premium until they take formal equity ownership in 3 years or so. Panic is high, vol is high, vol skew is high, the current dividend yield seems high; why not bet a tiny proportion of their portfolio?
What other financing choices did Citigroup have? Why not a domestic investor like Berkshire Hathaway who DOES have the cash instead of a sovereign wealth fund? My guess is Warren Buffett did not want to tempt fate from a similar situation he had ages ago with Salomon, now part of … Citigroup. In September 1987, as a “white knight” he bought a Salomon convertible preferred with a similar “high” dividend (9% then) and “low” conversion price. Interestingly the deal was done with the stock at 31 and convertible at 38, almost the same situation as now. A few weeks later came the October crash of that year obviously taking Salomon stock way down. The price subsequently climbed the next few years ALMOST to the strike. But then the Treasury Bond scandal erupted hurting the stock price again. Ultimately it was a fair trade for BRKA but I doubt they had appetite for a repeat.
Actually there might have been an even “cheaper” financing source for Citi. Hedge funds might have been interested. After all Citadel just poured $2.5 billion into E-Trade ETFC. And RAB Capital and SRM Global FAILED to catch that falling knife called Northern Rock NRK.L. Trading the optionality and mispricings in large bank mandatory convertibles has been quite lucrative over the years. When time ran out for the Japanese city banks, convertibles were issued for similar reasons and turned out to be both good investments and trading vehicles for volatility monetization.
We may yet see futher equity financing emerge for Citigroup and they will be glad to have got an initial $7.5 billion done with a stable investor who won’t short sell the common stock as a hedge, which is what I would have done. The structure also offers ADIA improved terms if Citi needs more than another $5 billion which it probably does. With ordinary covertible bond issuance so much “pre-hedging”, “pre-bookbuilding” and “wall-crossing” goes on that it would have forced the equity price down even more. Less negative effect on the stock price is a reason mandatory CBs are preferable for the issuer than ordinary CBs.
With some financial engineering and restructuring of cashflows the 11% coupon could probably have been as 0% or 20% by changing various preferential rights, the capital structure, optionality, convert strikes or other aspects of the deal. What would the headlines have said then? “0% – Massive vote of confidence in Citigroup as it borrows at 400bp less than the US government?” or “20% – Citigroup forced to pay far above subprime rates as bankruptcy looms?”. The reality is that this was effectively a forward sale of equity with a yield enhancing option premium NOT debt finance.
Commentary ranges on the pricing from Citibank junk bond to the more accurate and remarkably cheap Libor+150bp. Academic John Bilson even thinks there weren’t any hidden options at all which explains why he is a finance professor! Those who know, do; those who don’t know, teach; those who haven’t a clue become tenured economics professors.
While the “experts” say markets are becoming efficient and opportunities getting arbitraged out, it is reassuring to see disagreement on this, and in fact, every security. The more complex, interconnected and innovative global investment products get, the more skill is required to understand and value them. That is why it is worth paying 2 and 20 to those able to identify mispricings in the markets and capitalize upon them. And why alpha really is portable; it transports itself from the many market participants and financial geniuses that think they understand to the few that really do. Quality expertise costs.
It doesn’t matter what country an investor is in or whether they are institutional, high net worth or low net worth; the requirements are basically the same. Reliable absolute returns with MINIMAL drawdowns and volatility, performance that MORE than compensates for the risk and fund managers who can tell at a glance if a security is ultimately debt or equity and have the models and experience to value it. Detecting embedded options in capital raising structures helps too.
Proposes Amendments to Compliance Rule 2-45
The National Futures Association (NFA) proposed new amendments to Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties. The amendment states that no Member CPO may permit a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity. The amendment is proposed in response to a recent NFA investigation which revealed that CPOs had misappropriated pool funds through improper loans from pools to the CPOs or related entities. The full NFA proposal can be viewed below.
May 27, 2009
Via Federal Express
Mr. David Stawick
Office of the Secretariat
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, N.W.
Washington, DC 20581
Re: National Futures Association: Prohibition of Loans by Pools to Commodity Pool Operators and Related Parties – Proposed Adoption of Compliance Rule 2-45
Dear Mr. Stawick:
Pursuant to Section 17(j) of the Commodity Exchange Act, as amended, National Futures Association (“NFA”) hereby submits to the Commodity Futures Trading Commission (“CFTC” or “Commission”) proposed Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties. This proposal was approved by NFA’s Board of Directors (“Board”) on May 21, 2009. NFA respectfully requests Commission review and approval.
(additions are underscored)
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PART 2 – RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION
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RULE 2-45. PROHIBITION OF LOANS BY COMMODITY POOLS TO CPOS AND AFFILIATED ENTITIES.
No Member CPO may permit a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity.
EXPLANATION OF PROPOSED AMENDMENTS
In February, NFA took two Member Responsibility Actions (”MRAs”) against three NFA Member commodity pool operators (”CPOs”). Although the basis of both MRAs was the CPOs’ failure to cooperate with NFA in an investigation, the limited investigation that NFA was able to perform revealed that the CPOs had misappropriated pool funds through improper loans from pools to the CPOs or related entities. The CFTC charged all three of the CPOs with misappropriating pool assets through improper loans, and all three were charged criminally with fraud.
These two matters are not the first instances of CPOs misappropriating pool participant funds through direct or indirect loans from a pool to the CPO or a related entity. Over the years, there have been a number of regulatory actions involving this type of fraud. Given the significant losses suffered by pool participants as a result of these improper loans, NFA is proposing to prohibit direct or indirect loans from commodity pools to the CPO or any affiliated person or entity.
NFA staff discussed this matter with NFA’s CPO/CTA Advisory Committee, which supported prohibiting loans because it believes that absent extraordinary circumstances there is no legitimate reason for a pool to make a direct or indirect loan to its CPO or a related party. The Committee indicated, however, that participants, including a CPO’s principal, should not be prevented from borrowing against their equity interest in the pool.
NFA Compliance Rule 2-45 provides for a complete prohibition of direct or indirect loans or any advance of pool assets between a pool and its CPO or any other affiliated person or entity. NFA recognizes that there may be circumstances where a carve out to this prohibition may be appropriate, such as where a CPO permits participants, including a pool’s general partner, to borrow against their equity interest in the pool in lieu of a withdrawal, provided that the loan is collateralized by the participant’s interest in the pool. NFA believes that these types of situations are best handled on a case by case basis, with the CPO seeking a no-action letter from NFA.
NFA respectfully requests that the Commission review and approve proposed Compliance Rule 2-45 regarding prohibition of loans by pools to commodity pool operators and related parties.
Thomas W. Sexton
Senior Vice President and General Counsel
- CPO Annual Report Guidance
- Hedge Fund CPO Exemptions
- How to Register as a CPO
- CPO Exemption for Fund of Hedge Funds
- NFA CPO Actions
The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.
Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. The amendments are summarized in the bullet points below:
Rule 206(4)-2: All registered investment advisers:
- must have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients
- must undergo an annual surprise audit examination by an independent accountant
- is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services
- must obtain or receive an annual internal control report, if the adviser also acts as a qualified custodian over client assets
- must inform the SEC within one business day of finding any material discrepancies during an audit examination
Rule 204-2: All registered investment advisers:
- must maintain a copy of an internal control report for five years from the end of the fiscal year in which the internal control report is finalized
Form ADV: All registered investment advisers:
- must report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds
- must report the dollar amount of client assets and the number of clients of which he/she has custody
- must identify and provide detailed information regarding the accountants that perform the audits/examinations and prepare internal control reports
Form ADV-E: All PCAOB-registered accountants:
- must file Form ADV-E with the SEC within 120 days of the completion of the audit examination
- must submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes details of the resignation
All comments to the proposed amendments must be received by the SEC on or before July 28, 2009. Please contact us if you have any questions on the above proposed amendments or would like to start a hedge fund. Additionally, we will be submitting our comments to the SEC with regard to the proposed amendments and would like to know what you think as well – please comment below.
For further information regarding the proposed amendments, please refer to the more detailed abstract below. The full text of the proposed rules can be found here.
SEC Proposed Custody Amendments Abstract
The Securities and Exchange Commission (SEC) is proposing certain amendments to the custody rule under the Investment Advisers Act of 1940 and related forms, with the intent to enhance the protections afforded to clients’ assets under the Advisers Act when an advisor has custody of client funds or securities. These amendments are proposed as a response to a number of recent enforcement actions against investment advisors alleging fraudulent conduct, including misappropriation or other misuse of investor assets. Specifically, the amendments address Rules 206(4)-2 and 204-2, and Forms ADV and ADV-E. Due to the complexity of the various impositions placed on industry professionals by the proposed amendments, the SEC is formally requesting feedback from industry professionals regarding the impact of the new legislation.
Rule 206(4)-2, also known as the ‘custody rule’, seeks to protect clients’ funds and securities in the custody of registered advisers from misuse or misappropriation by requiring advisers to implement certain controls. The current rule requires registered advisers to maintain their clients’ assets in separate identifiable accounts with a qualified custodian, such as a broker-dealer or bank. Presently, advisors may comply with the rule by either a) having a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients or alternatively b) the advisor sending his/her own quarterly account statements to clients and undergoing an annual surprise audit examination by an independent public accountant. Similarly, an adviser to a pooled investment vehicle may currently comply with the rule by having the pool audited annually by an independent public accountant and distributing the audited financials to the investors in the pool within 120 days of the end of the pool’s fiscal year.
The proposed amendments to Rule 206(4)-2 aim to codify both of the above mentioned compliance alternatives by requiring that all registered advisers having custody of client assets must a) have a reasonable belief that a qualified custodian sends quarterly account statements directly to the advisory clients and b) undergo an annual surprise examination. The amendments also explicitly state that an adviser is presumed to have custody over any clients’ assets that are maintained by the advisers ‘related persons’, so long as those assets are in connection with the advisory services. The SEC additionally proposes that if an independent qualified custodian does maintain client assets, but rather the advisor or a related person him/herself serves as a qualified custodian for the client, then the advisor must obtain or receive from the related person an annual internal control report which would include a) an opinion from an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and b) a description of the relevant controls in place relating to custodial services and the objectives of these controls, as well as the accountant’s tests of operating effectiveness and the test results. Lastly, the newly amended rule would also require the adviser and the accountant to inform the SEC within one business day of finding any material discrepancies during an examination that may assist in protecting advisory client assets. Together, these revisions to Rule 206(4)-2 are designed to strengthen the controls relating to the advisors’ custody of client assets and deter advisors from fraudulent activity.
Rule 204-2, governing record maintenance, presently requires that investment advisors obtain or receive a copy of an internal control report from its related person. The proposed amendment to this rule would additionally require the advisor to maintain the copy for five years from the end of the fiscal year in which the internal control report is finalized. This amendment to Rule 204-2 is designed to further implement safeguards to protect clients’ assets and offset custody-related risks.
Form ADV, which outlines the data to be reported to the SEC by investment advisors, has also been amended to provide the SEC with additional data and more complete information from the perspective of the advisor. Currently, Item 7 of Part1A requires advisers to report on Schedule D of Form ADV each related person that is an investment adviser, and permits advisers to report the names of related person broker-dealers. The new amendment modifies Item 7 to require an advisor to report all related persons who are broker-dealers and to identify which, if any, serve as qualified custodians with respect to client funds. Similarly, Item 9 of Part1A currently requires advisers to report whether they or a related person have custody of client funds. The new amendment to Item 9 requires an adviser to report the dollar amount of client assets and the number of clients of which he/she has custody. Other reporting duties to be implemented under the new amendments include: a) whether a qualified custodian sends quarterly account statements to investors in pooled investment vehicles managed by the adviser, b) whether these account statements are audited, c) whether the adviser’s clients’ funds are subject to a surprise examination and the month in which the last examination commenced, and d) whether an independent PCAOB-registered accountant prepare an internal control report when the adviser is also acting as a qualified custodian for the clients’ funds. Schedule D of Form ADV would also be amended to require additional reporting duties of the adviser, including: a) identifying the accountants that perform the audits/examinations and prepare internal control reports, b) providing information about the accountants including address, PCAOB registration, and inspection status, c) indicating the type of engagement (audit, examination, or internal control report), and d) indicating whether the accountant’s report was unqualified. These proposed amendments to Form ADV are designed to allow the SEC to better monitor compliance with the requirements of Rules 206(4)-2 and 204-2 and better assess the compliance risks of an adviser.
Form ADV-E, which outlines the data to be reported to the SEC by designated accountants, has also been amended to provide the SEC with additional data and more complete information to the SEC from the perspective of the accountant. Currently, the rule requires this form to be filed within 30 days of the completion of the examination, accompanied by a certificate confirming that the accountant completed an examination of the funds and describing the nature and extent of the examination. The SEC proposes to amend this rule governing Forms ADV and ADV-E to extend the grace period within which the forms must be submitted to a period of 120 days from the time of the examination. Based on SEC observations, an adviser’s surprise examination may sometimes continue for an extended period of time, warranting this extension. Additionally, the amendment requires that the accountant submit Form ADV-E to the SEC within four business days of his/her resignation, dismissal from, or other termination of the engagement, accompanied by a statement that includes a) the date of such resignation, dismissal or termination, b) the accountant’s name, address and contact information, and c) an explanation of any problems relating to examination scope or procedure that contributed to such resignation, dismissal or termination. This proposed amendment to Form ADV-E is designed to provide the SEC with the information necessary to further evaluate the need for an examination to determine whether the clients’ assets are at risk.
The SEC strongly urges investment advisors, public auditors/accountants, and related professionals in the field of securities and investments to review the proposed amendments to the Advisers Act and submit relevant feedback that may assist the Commission in analyzing the effectiveness, efficiency, and feasibility of the proposed amendments as well as the possible impact of these new legislative measures on the global marketplace. While all proposed amendments are designed to provide additional safeguards to client funds or securities under adviser custody, the potential ramifications of their enforcement is currently being assessed. Comments may be submitted in electronically via the Commission’s internet comment form (http://www.sec.gov/rules/proposed.shtml), via e-mail to email@example.com, or via the Federal eRulemaking Portal (http:/www.regulations.gov). Paper comments can be sent in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. All comments to the proposed amendments must be received by the SEC on or before July 28, 2009. All submissions must refer to File Number S7-09-09, and will be made available to the public via the Commission’s Internet Website: http://www.sec.gov/rule/proposed.shtml.
As we have discussed previously, if a hedge fund manager invests fund assets in commodity interests (including futures), then the manager will generally need to be registered as a commodity pool operator (CPO) with the Commodity Futures Trading Commission (CFTC). The registration requirement also applies to fund of fund (FOF) managers who allocate assets to underlying hedge funds which themselves invest in commodity interests. There are a number of CPO exemptions available to hedge fund managers. Likewise, there are two exemptions which may be applicable to fund of fund managers who allocate to funds CPOs or exempt CPOs.
The two potential exemptions are found in 4.13(a)(4) and 4.13(a)(3) which we will deal with in turn.
Only Qualified Purchasers. Pursuant to CFTC Regulation 4.13(a)(4), if the FOF has only qualified eligible persons (QEP), then it will not need to register as a CPO. Generally qualified purchasers will qualify as QEPs and so hedge funds which are established as Section 3(c)(7) funds will be able to qualify for this exemption.
De Minimus Futures Trading. Pursuant to CFTC Regulation 4.13(a)(3), if the FOF only has a very small amount of assets allocated to commodity interests, it will not need to register as a CPO. The test under 4.13(a)(3) is the same as for a regular fund, but the application is different because the structure of the FOF. Because of the ambiguity, the CFTC specifically provided guidance for FOF managers which allocate to funds which invest in commodity interests.
Note: 4.13(a)(1) and 4.13(a)(2) are also available exemptions, however, these are less often used and are unlikely structures for FOFs.
Three Most Likely Situations
Most FOF managers will fall within the 4.13(a)(3) trading limits (and thus would be exempt from CPO registration) in the following circumstances:
- All underlying funds all trade within the 4.13(a)(3) trading limits;
- The FOF manager aggregates all commodity interest positions from the underlying funds to determine if the trading falls within the 4.13(a)(3) limits; or
- The FOF manager allocates no more than 50% of the FOF assets to funds which trade commodity interests (and the FOF does not trade commodity interests itself).
I have included the actual language from the CFTC adopting release below which provides examples from the CFTC of situations where the FOF manager would fall within the exemption. Please contact us if you have a question on this issue or if you would like to start a fund of hedge funds. If you would like more information, please see our articles on starting a hedge fund.
b. New Appendix A to Part 4: “Fund-of-Funds”
Most of the commenters on proposed Rule 4.13(a)(3), and in fact, on the Proposal as a whole, expressed concern over the application of the Rule 4.13(a)(3) trading limits in the “fund of funds” context. They requested the Commission to confirm in its final rulemaking statements it had made in the Proposal on this issue. They also presented numerous scenarios involving “fund-of-funds” structures for the Commission to consider.
 In the ANPR, the Commission defined a “fund-of-funds” as an investor fund that indirectly trades commodity interests through participation in one or more investee funds that directly trades commodity interests. See 67 FR 68785, 68788, n.15.
 See 68 FR 12622, 12631.
To address these concerns, the Commission is adopting today Appendix A to Part 4. The introductory text explains that:
The following provides guidance on the application of the trading limits of Rule 4.13(a)(3)(ii) to commodity pool operators (CPOs) who operate “fund-of-funds.” For the purpose of this Appendix A, it is presumed that the investor fund CPO can comply with all of the other requirements of Rule 4.13(a)(3). It also is presumed that where the investor fund CPO is relying on its own computations, the investor fund is participating in each investee fund that trades commodity interests as a passive investor, with limited liability (e.g., as a limited partner of a limited partnership or a non managing member of a limited liability company). Fund-of-fund CPOs who seek to claim exemption from registration under Rule 4.13(a)(1), (a)(2) or (a)(4) may do so without regard to the trading engaged in by an investee fund, because none of the registration exemptions set forth in those rules concerns limits on or levels of commodity interest trading. Persons whose fact situations do not fit any of the scenarios below should contact Commission staff to discuss the applicability of the registration exemption in Rule 4.13(a)(3) to their particular situations.
In adopting Appendix A, the Commission has been guided by the following principles, i.e., that relief under Rule 4.13(a)(3) should be available where:
(1) The CPO of each investee fund is either: (i) itself claiming exemption from CPO registration under Rule 4.13(a)(3); or (ii) a registered CPO that is complying with the trading restrictions of Rule 4.13(a)(3). In this regard, the CPO of the investor fund should be able to rely upon the representations of the investee fund CPOs to the foregoing effect.
(2) The CPO of an investor fund has actual knowledge of the trading and commodity interest positions of the investee funds (e.g., where the investee funds are operated by the CPO or one or more affiliates of the CPO). In this case the investor fund CPO may aggregate the commodity interest positions across the investee funds to determine compliance with the trading restrictions of Rule 4.13(a)(3).
(3) An investor fund does not trade commodity interests directly, and the CPO has allocated no more than 50 percent of the investor fund’s assets to investee funds that trade commodity interests (regardless of the level of commodity interest trading engaged in by those investee pools). The investor fund CPO may claim exemption under Rule 4.13(a)(3) because the investor fund’s exposure to the futures markets may be said to be comparable to that of a standalone pool that meets the aggregate net notional value test.
(4) An investor fund engages in direct commodity interest trading in addition to its allocation of assets to investee funds, provided the CPO treats the assets committed to direct trading as a separate pool with its own liquidation value and applies the trading restrictions of Rule 4.13(a)(3) to that “separate pool.
APPENDIX A TO PART 4 – GUIDANCE ON THE APPLICATION OF RULE 4.13(a)(3) IN THE FUND-OF-FUNDS CONTEXT
The following provides guidance on the application of the trading limits of Rule 4.13(a)(3)(ii) to commodity pool operators (CPOs) who operate “fund-of-funds.” For the purpose of this Appendix A, it is presumed that the CPO can comply with all of the other requirements of Rule 4.13(a)(3). It also is presumed that where the investor fund CPO is relying on its own computations, the investor fund is participating in each investee fund that trades commodity interests as a passive investor, with limited liability (e.g., as a limited partner of a limited partnership or a non-managing member of a limited liability company). Fund-of-fund CPOs who seek to claim exemption from registration under Rule 4.13(a)(1), (a)(2) or (a)(4) may do so without regard to the trading engaged in by an investee fund, because none of the registration exemptions set forth in those rules concerns limits on or levels of commodity interest trading. Persons whose fact situations do not fit any of the scenarios below should contact Commission staff to discuss the applicability of the registration exemption in Rule 4.13(a)(3) to their particular situations.
1. Situation: An investor fund CPO allocates the fund’s assets to one or more investee funds, none of which meets the trading limits of Rule 4.13(a)(3) and each of which is operated” by a registered CPO. It does not allocate any of the investor fund’s assets directly to commodity interest trading.
Application: The investor fund CPO may claim relief under Rule 4.13(a)(3) provided the investor fund itself meets the trading limits of Rule 4.13(a)(3).
2. Situation: An investor fund CPO allocates the fund’s assets to one or more investee funds, each having a CPO who is either: (1) itself claiming exemption from CPO registration under Rule 4.13(a)(3); or (2) a registered CPO that is complying with the trading restrictions of Rule 4.13(a)(3). It does not allocate any of the investor fund’s assets directly to commodity interest trading.
Application: The investor fund CPO fund may rely upon the representations of the investee fund CPOs that they are complying with the trading limits of Rule 4.13(a)(3).
3. Situation: An investor fund CPO allocates the fund’s assets to investee funds, each of which operates under a percentage restriction on the amount of margin or option premiums that may be used to establish its commodity interest positions (whether pursuant to Rule 4.12(b), Rule 4.13(a)(3)(i)(A) or otherwise), by, e.g., contractual agreement. It does not allocate any of the investor fund’s assets directly to commodity interest trading.
Application: The CPO of the investor fund may multiply the percentage restriction applicable to each investee fund by the percentage of the investor fund’s allocation of assets to that investee fund to determine whether the CPO is operating the investor fund in compliance with Rule 4.13(a)(3)(i)(A).
4. Situation: An investor fund CPO allocates the fund’s assets to one or more investee funds, and it has actual knowledge of the trading limits and commodity interest positions of the investee funds, e.g., where the CPO or one or more affiliates of the CPO operate the investee funds. (For this purpose, an “affiliate” is a person who controls, who is controlled by, or who is under common control with, the CPO.) It does not allocate any of the investor fund’s assets directly to commodity interest trading.
Application: The investor fund CPO may aggregate commodity interest positions across investee funds to determine compliance with the trading restrictions of Rule 4.13(a)(3). For this purpose, the aggregate assets of the investee funds would be compared to the aggregate of their commodity interest positions (as to margin or as to net notional value ). The investor fund CPO should use the results of this computation to determine its compliance with the trading limits of Rule 4.13(a)(3).
5. Situation: An investor fund CPO allocates no more than 50 percent of the fund’s assets to investee funds that trade commodity interests (without regard to the level of commodity interest trading engaged in by those investee pools). It does not allocate any of the investor fund’s assets directly to commodity interest trading.
Application: The investor fund CPO may claim relief under Rule 4.13(a)(3).
6. Situation: An investor fund CPO allocates the fund’s assets to both investee funds and direct trading of commodity interests.
Application: The investor fund CPO must treat the amount of investor fund assets committed to such direct trading as a separate pool for purposes of determining compliance with Rule 4.13(a)(3)(i), such that the commodity interest trading of that pool must meet the criteria of Rule 4.13(a)(3)(i) independently of the portion of investor fund assets allocated to investee funds.
NFA Compliance Rule 2-43 Outlaws Forex “Hedging” For NFA Registered Forex Dealers
(www.hedgefundlawblog.com) The new forex regulations have affected the industry in a number of ways. Rule 2-43 especially has been a source of ire for some forex managers who have utilized a “hedging strategy” as part of their investment program. In the forex hedging strategy a trader will have both a long and a short position in a single currency pair. While these positions are essentially offsetting, some trend following forex traders will hold such positions in order to profit once a trend has been detected. This strategy was effectively eliminated by the passage of Rule 2-43 for managers trading with forex firms which are registered with the CFTC and NFA Member firms.
This rule provides an opening for offshore forex dealers (who are not NFA Members) to offer this strategy to forex traders. What you are likely to see, then, is an exodus of trading capital to those brokers which allow hedging strategies (see the two press releases below). I can think of no clearer example of how regulation is actually forcing capital to go overseas where forex brokers may face lower levels of regulation. This in turn may actually make forex traders more susceptible to fraudulent practices at the brokerage level (when they trade in countries with less regulation). Interestingly enough, this movement of money to offshore forex dealers was predicted by the US forex dealers when the rule was announced.
From NFA Release on Compliance Rule 2-43
Although many of the FDMs admit that customers receive no financial benefit by carrying opposite positions, some FDMs believe that if they do not offer the strategy they will lose business to domestic and foreign firms that do.
While some traders may move money to offshore forex dealers, these traders should, however, beware that by trading forex with a non-NFA member firm, they may become subject to state level regulation (and accordingly CFTC registration). As this is a developing and complex area of law, I always advise forex managers to discuss their business operations with an experienced forex attorney.
InvestTechFX To Continue Forex HEDGING For Traders After NFA Ruling
InvestTechFX released today that the 1 PIP Forex Corporation will continue to allow all types of hedging after the NFA (National Futures Association) ruling against hedging goes into effect on May 15, 2009. As InvestTechFX is not an NFA regulated broker, it is not obligated to adhere to the NFA’s anti-hedging policies. www.investtechfx.com
Toronto, Canada (PRWEB) April 24, 2009 — InvestTechFX the leading 1 PIP Forex Corp commented on the NFA’s new anti-hedging law (NFA Compliance Rule 2-43 regarding Forex orders) currently scheduled to take effect on May 15th, 2009, and released that the No Dealing Desk Forex broker and Software Solutions Corp will be immune to the new law. InvestTechFX’s industry expert noted that the NFA’s move is not entirely unexpected; the spirit of the new regulation is to protect traders from wasteful over-hedging, but the practical implications of the new regulations will likely be counter-productive. Traders who rely on hedging in their strategies will simply take their business to brokers outside the influence of the NFA, such as InvestTechFX. Ironically, the NFA may put US Forex brokers at a disadvantage by barring them from providing the hedging options that their international competitors will not hesitate to offer.
InvestTechFX the leading 1 PIP Forex Corp welcoming hedging explained that “hedging” generally refers to the practice of taking opposite positions against a previous open position in order to reduce risk. In a broader sense, hedged trading means investing to limit exposure and reduce risk. There are several methods of hedging Forex positions, particularly opening short and long positions within the same currency pair at the same time. This type of hedging will be much more difficult after May 15th, 2009, as the new regulations will put strict limits on such strategies. Positions opened prior to May 15th will not be penalized under the new rule, but all positions opened after the initiation date will be effected. Traders who want to continue hedging while staying with an NFA-regulated broker may now have to open separate accounts for their long positions and short positions; something not all traders can afford to do.
InvestTechFX the leading 1 PIP Forex Corp. welcoming hedging strategies noted that new restrictions on hedging are not the only new regulations set forth in the NFA’s new ruling. After May 15th, 2009, all NFA brokers will have to notify traders in writing prior to adjusting or manipulating trades, with the exception of instances in which the adjustment is favorable to a trader or at a trader’s request. Furthermore, the written notification of intent to adjust must take place within 15 minutes or less of the time of execution. This new regulation (Rule 2-43a) will not be going into effect until June 12th, 2009. In regard to customer orders adjusted because of changes in the price structure of a liquidity provider, written notification must be given to customers prior any initial trading (price increases on the account of transaction clearing must be stated before trading takes place, not after or during trading). InvestTechFX’s analyst explained that these new regulations are likely an attempt to increase cost transparency and reduce the hidden fees that many brokers, particularly market makers, rely upon to limit customer profits. Since market makers must always provide the counterparty for a trade (always buy from a seller and sell to a buyer), there is a strong ulterior motive to undercut customer profits, as customer profits always come at the market maker’s expense.
InvestTechFX the leading 1 PIP Forex Corp. welcoming hedging’s analyst elaborated on the threat of expanding regulation in the Forex market, and the unforeseen consequences that well-meaning regulation agencies can impose upon the market. Forex trading is a fast-growing, highly competitive industry, and because of its inherently global nature, traders are not limited to the Forex providers in their own countries. While many would likely work with a local broker, traders can relatively easily move their business abroad if regulation in their own regions becomes more of a burden than a protection. Government guidelines regarding trading clear policies and risk disclosure can serve to keep the industry legitimate and transparent, but regulating hedging in this way borders on telling traders what strategies they can and can’t use. There is ongoing debate over who the NFA is “protecting” with the new policies, as many of the larger regulatory bodies have a reputation for acting out of the long-term interests of companies instead of retail traders. InvestTechFX’s representative explained that the company could not decisively endorse or condemn the use of mirror position hedging, but did state that the position of InvestTechFX is that the decisions regarding trading strategies should be left to the traders, not the regulators.
InvestTechFX the leading 1 PIP Forex Corporation welcoming hedging is a No Dealing Desk Forex Broker and Federal Canadian Corporation. InvestTechFX offers a 1 PIP fixed spread on 6 major currency pairs, along with a comprehensive account groups system, including interest free, scalping, EA, Micro, and VIP accounts. As a No Dealing Desk, InvestTechFX never takes positions against customers, and has no interest or influence over the trades executed by its customers. www.investtechfx.com
New Forex Trading Rule by NFA About Hedging Positions Will Change the Trading Game
Forex market is getting revised by continuous trade rule changes. In such uncertain times, Forex Profit Farm may be the perfect solution for people looking to succeed in forex trading.
New York, NY (PRWEB) April 30, 2009 — The forex market is booming with addition of new players every minute because of the high and lucrative potential of making money. Such fast growth poses its own challenges, but at the same time also present with the opportunity to redefine the industry by writing new rules or guidelines.
One such rule that NFA came up with recently is regarding Anti-Hedging. This rule is coming into effect starting 15 may 2009. As per this new law, the trader community cannot create hedged trades.
Rahul Gupta, owner of Forex Profit Farm says, “Currently a forex trader can have two opposite directional trades open at the same time on a single currency pair. So say if you are trading EUR/USD currency pair, you can have short as well as a long trade opened at the same time, which is what is called hedging. The traders do that mostly to judge the direction of the market. Though a hedged open long and short trade on a single currency pair will offset the gain of one position against the other, but when the direction of market trend becomes clear, traders close the losing trade and keep the winning one going. It is a cruel way to trade, but it is very common.”
With that now going to be not possible come May 15, 2009, all traders who use such forex trading practices, will now have to come up with different trading strategies. This is a clear concrete step by NFA to make the forex industry more mature and keep the exponential growth under check.
But Rahul says “Traders who are using best forex trading system don’t have to worry about anything at all. A good trading strategy is independent of such techniques and always remain non-effected from changing rules of similar nature. Traders who use sound trading principles, won’t feel the effect of this new rule at all.”
This is very true because National Future Association (NFA) has passed this new rule to make the unfair practices offered by some of the traders as ineffective, but at the same time preserve the interest of the experienced traders who trade forex for a living.
Like any new rule which is introduced by a governing body, this one also has its share of traders opposing it, but most of the experienced traders see it as a positive step towards regulating the forex trading industry. In such time, a sound trading strategy is all that a trader needs to keep making money by selling one currency against other.
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Hedge Funds to be Subject to “Surprise Exams”
In addition to the likelihood of hedge fund registration, the SEC is now proposing to have “gatekeepers” to make sure that investment advisors are not engaged in any fraudulent behavior. When and if such a requirement is adopted, it will further burden investment advisors with more paperwork. “Surprise exams” could also be disastrous to the small investment advisory shops which would need to divert resources from trading and operations to dealing with such surprise exams. At all levels of the investment advisory spectrum this will increase costs.
SEC Proposes Rule Amendments to Strengthen Safeguards of Investor Funds Controlled by Investment Advisers
FOR IMMEDIATE RELEASE
Washington, D.C., May 14, 2009 — The Securities and Exchange Commission today proposed rule amendments to substantially increase protections for investors who entrust their money to investment advisers.
The SEC is seeking public comment on the proposed measures, which are intended to ensure that investment advisers who have “custody” of clients’ funds and securities are handling those assets properly. In some recent SEC enforcement actions, firms and principals have been charged with misusing clients’ money and covering up their illicit activities by distributing false account statements showing non-existent funds. The additional safeguards proposed by the SEC include a yearly “surprise exam” of investment advisers performed by an independent public accountant to verify client assets. In addition, when an adviser or an affiliate directly holds client assets, a custody control review would have to be conducted by a PCAOB-registered and inspected accountant.
“These new safeguards are designed to decrease the likelihood that an investment adviser could misappropriate a client’s assets and go undetected,” said SEC Chairman Mary Schapiro. “That’s because an independent public accountant will be looking over their shoulder on at least an annual basis.”
Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “The amendments proposed by the Commission today would significantly strengthen controls over client assets held by registered investment advisers — especially when those assets are held directly by the adviser itself or a related person of the adviser.”
Unlike banks or broker-dealers, investment advisers generally do not have physical custody of their clients’ funds or securities. Instead, client assets are typically maintained with a broker-dealer or bank (a “qualified custodian”), but the adviser still may be deemed to have custody because the adviser has authority to withdraw their clients’ funds held by the qualified custodian. Or the qualified custodian may be affiliated with the adviser, which may give the adviser indirect access to client funds.
The SEC’s proposed rule amendments, if adopted, would promote independent custody and enable independent public accountants to act as third-party monitors.
One proposed amendment would require all registered advisers with custody of client assets to undergo an annual “surprise exam” by an independent public accountant to verify those assets exist.
Another proposed amendment would apply to investment advisers whose client assets are not held or controlled by a firm independent of the adviser. In such cases, the investment adviser will be required to obtain a written report — prepared by a PCAOB-registered and inspected accountant — that, among other things, describes the controls in place, tests the operating effectiveness of those controls, and provides the results of those tests. These reports are commonly known as SAS-70 reports. This review would have to meet PCAOB standards — providing an important level of quality control over the accountants performing the review.
The proposed measures also would include reporting requirements designed to alert the SEC staff and investors to potential problems at an adviser, and provide the Commission with important information for risk assessment purposes. An adviser would be required to disclose in public filings with the Commission, among other things, the identity of the independent public accountant that performs its “surprise exam,” and amend its filings to report if it changes accountants. The accountant would have to report the termination of its engagement with the adviser and, if applicable, any problems with the examination that led to the termination of its engagement. If the accountants find any material discrepancies during the surprise examination, they would have to report them to the Commission.
The proposed amendments also would require that all custodians holding advisory client assets directly deliver custodial statements to advisory clients rather than through the investment adviser, and that advisers opening custody accounts for clients instruct those clients to compare account statements they receive from the custodian with those received from the adviser. These additional safeguards would make it more difficult for an adviser to prepare false account statements, and more likely that clients would find discrepancies.
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Public comments on today’s proposed rule amendments must be received by the Commission within 60 days after their publication in the Federal Register.
The full text of the proposed rule amendments will be posted to the SEC Web site as soon as possible.