Fishy Business

[Jcrew]

I had bought some puts a year ago on WCI that expire this week. Anyways, I've been quite frustrated with its recent price movements within the past few months. At its low point around 14, a hedge fund, Basswood Partners, coverted its 1.7 million shares to the equivalent worth of March 07 exp calls with a strike price of 17.5. At the time, it seems like a curious move. Now it seems like an unbelievable prescient move. Since then major players like Gates Fund, Carl Ichan, and Cohen have bought into the company making a run at the heavily short positions.

Anyways this situation made me think of how the Princple-Agent problem can fester itself in the financial world. Bob manages a hedge fund and is buddies with Jack who manages a major mutual fund. Jack is invested in Bob's fund.

Situation A)
Jack tells Bob what moves he is going to make prior to making them costing Jack's fund a slightly higher buy-in price, or lower sell-off price, while making Jack and Bob $$$.

Situation B)
Bob makes a several bad decision in buying into several companies. Tells Jack about it. When it comes time in deciding what companies to buy, Jack has a choice between the companies Bob invested, and companies that are comparable but inside he believes have a slighter greater EV than Bob's group. However Jack's EV is much greater if he decides goes with Bob's group.

[DesertCat]

[ QUOTE ]

Situation A)
Jack tells Bob what moves he is going to make prior to making them costing Jack's fund a slightly higher buy-in price, or lower sell-off price, while making Jack and Bob $$$.


[/ QUOTE ]

They both don't make money. Jack's fund loses, and Bob's gain, if and only if, they are so large they affect the market. Jack may make some money back as an investor in the hedge fund, but it's hard to see him making enough to offset what he cost his fund (unless he gets kickbacks directly from Bob's performance fees). Remember, the mutual fund doesn't get performance fees, but the size of it's asset base is related to how successful it is. Jack's making it harder to keep his own job, so he can make a little extra money on an investment in some hedge fund.

And why wouldn't Jack just wait until Bob is done, so he can get a higher sale price or lower buy price? Isn't that the best of both worlds?

[ QUOTE ]

Situation B)
Bob makes a several bad decision in buying into several companies. Tells Jack about it. When it comes time in deciding what companies to buy, Jack has a choice between the companies Bob invested, and companies that are comparable but inside he believes have a slighter greater EV than Bob's group. However Jack's EV is much greater if he decides goes with Bob's group.

[/ QUOTE ]

This only helps Bob if he's selling at the same time. If he's going to hold on to the stock, a blip in the price for one week isn't going to help him. The ultimate return is driven by the long term price action of the stock, and that's driven by performance of the company. And if Bob is selling at the same time Jack is buying, one of them is making a mistake.

There are many ways that mutual funds and hedge funds "tweak" their performance, and they don't require a "principle-agent" relationship. One way is that funds can buy up their best stocks on the last week or day of their reporting periods, to report an artificially higher end price and hence portfolio performance.

The problem with these "tweaks" is that they usually involve trading better short term for worse long term results. You like stock A, and buy it at $5 thinking it's a bargain because it's worth $10. At the end of your performance period it actually hits $9, so it's no longer a bargain. But you need to report higher numbers so you start buying it like crazy, driving it up close to $10. You've just increased your basis, and accepted a lower future return just to report a slightly higher NAV this quarter.

The mutual fund business is so short term focused that many managers participate in -EV schemes like this just to look a little better when the quarter or year is ended.

Another example of how funds can pursue self destructive strategies is the "market timing" scandal. Funds allowed traders to market time and reduced fund performance because it increased the size of the fund and hence their fees.

[Jcrew]

I guess I didn't communicate properly. My whole point was that in today's financial structure, there exists circumstances where the mutual fund manager can sacrifice a little bit of his fund's performance in return for large personal financial gains. Basically the return increases he creates for the hedge fund that he is personally invested would outweigh the bonuses he get if he just got that little extra performance out of the fund he manages.

[DesertCat]

Assume Jack could transfer gains directly from his fund to Bob's fund. Jack loses 2 cents for each dollar of gains he transfers (his funds management fee). Bob gains 22 cents for each dollar transferred (his 20% performance fee + 2% mgmt fee).

But what is Jack's share of Bob's increased profits? As a limited partner, he'll get his share of the remaining 88 cents of profit. Which means Jack needs to own about 2% of Bob's hedge fund, just to get his 2 cents back. That could be a very hefty investment, depending upon the hedge fund size. But essentially it's a very risky way to make a very small amount of money.

a) Jack is risking his job & jail time.
b) Bob is risking his fund and jail time.
c) This scheme doesn't work for Jack at all if Bob is a lousy investor.
d) It's difficult to transfer gains, buying and selling at the same time doesn't ensure anything.
e) If it works, Jack is reducing his own returns which will lead to a smaller fund and less pay.

Why wouldn't Jack just pull his money out of Bob's fund and put it in his own mutual fund? This way he's not reliant on Bob, doesn't face jail risk, and doesn't have to do anything to hurt his own career, and earns an additional 2% per year on his own mgmt fee.

People do stupid things all the time (like rob banks), so I wouldn't doubt this happens occasionally. But that doesn't make it an effective scheme.