Hedge Funds Flip-Flop

A recent examination of hedge funds by the Securities and Exchange Commission (SEC) found a variety of deficiencies in almost half of the firms examined, according to the Wall Street Journal.

None of the findings were particularly surprising, but the SEC appears to create a new name for an old problem: flip-flopping (and not on a wind-surfer).

The problem is that some securities, especially ones that are unique or illiquid, are hard to value.

Think of your house: it’s one of a kind and you don’t know what the value is until buyers actually show up. If you’re like me, you pay attention to recent transactions in your neighborhood and use those to come up with some way to value your house.

Let’s say that you simply look at the price-per-square-foot of each recent sale and then multiply that by the square feet in your home to come up with a valuation. That works well all year until one house that is kind of a dump, sells for a low price and the price-per-square-foot is unusually low.

For the mental accounting of your house, it’s no big deal. But what if you are paid based on the value of your house. If that transaction is at the end of the year, your pay is going down, so you decide to look at the price compared to area of the lot instead of the home itself.

Lo and behold, the price on this metric looks fine, so you switch your pricing policy to the new metric and your pay remains intact. That’s flip-flopping according to the SEC and they found that hedge funds were changed their pricing policies multiple times per year in an effort to manipulate the value of their holdings.

The incentives for hedge funds to engage in this kind of problem is particularly stark because not only do they earn a percentage of the assets that they hold, but also charge 20 percent of the profits (and are taxed at the capital gains rate on that profit allocation).

I’m reminded of an apocryphal story about a portfolio manager that calls a trader on the last day of the year and asks for a price on one of his holdings. Before answering, the trader asks, ‘is this for a bid or a mark?’

If you didn’t laugh uproariously at that joke, the trader is basically asking, ‘do you want a price to sell the security (a bid) or a price to put on your statement (a mark to market), because they are two different prices. I’ll bet you can guess which one will be higher.

Acropolis actually runs into this problem with some of our individual mortgage bond holdings. Unlike the hedge funds, though, we DO NOT price the securities and rely on third party pricing that comes from your custodian, which is usually Charles Schwab or TD Ameritrade. You should always be able to reconcile our reports with the statements of record from the custodian.

That’s not to say that those prices are right, unfortunately. It’s not uncommon to see prices in the market that are a percent or two different than what we see in the ‘matrix price’ sent down electronically by the custodian.

Thankfully, this doesn’t affect the vast majority of our holdings, which are priced continuously throughout the day (stocks and ETFs) or strike a net asset value after the market closes (mutual funds). When it does happen, like with the mortgage-bonds, the impact is relatively small.

Just as you would expect, we’re not flip-floppers!