Delaying Losses To Earn Current Fees

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Fee structure is a guiding force for how fund managers operate and a keystone for compliance professionals. A compliance professional needs to focus on ways that a fee structure could cause the fund manager to act to the detriment of fund investors. The Securities and Exchange Commission just charged a fund manager for using distorted timing to generate more fees.

Cash in the grass.

According the SEC complaint, Hope Advisors and its principal owner, Karen Bruton, distorted the trading patterns of its hedge fund it managed to maximize fees to the detriment of fund investors. Hope Advisors and Ms. Bruton are challenging the charges so I’m looking at the complaint as an example of problematic behavior and not that they actually did these things.

Hope was entitled to an incentive fee of 20% of any realized gains during the previous month. But first the fund needed to make up for any realized losses. Unrealized gains and unrealized losses were not used in calculating the incentive fee.

The PPM for the fund discloses that the incentive fee may be paid even though the fund is experiencing unrealized losses.

According to the SEC, Hope was causing the fund to realize gains currently by deferring current unrealized losses through options. The fund would sell call options in the current month, earning a fee, and buy an equivalent set of options that expired in the next month. The SEC claims that there was no economic substance to the trades because there was little chance to make or lose money regardless of the market’s direction.

The fund would keep kicking the unrealized losses into the next month, while still taking fees. The fund had an NAV of $136 million, with unrealized losses of $57 million.

According to the statements in the complaint, it seems that Hope was acting to the detriment of fund investors. However, this behavior and risk is disclosed in the PPM.

Is disclosure enough for this circumstance?

I think trades that have no economic benefit (or risk) to the fund investors but are done merely to increase a fund managers compensation are suspect. Compliance professionals should look closely to see if the trade is merely done to benefit the fund manager.

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Author: Doug Cornelius

You can find out more about Doug on the About Doug page

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