Fund Prices: From Fuzzy to Opaque
Javier Martin-Artajo and Julien Grout aren’t household names. They are two JP Morgan traders who stand accused by the US Justice Department of systematically mispricing complex derivatives securities in the bank’s Chief Investment Office. They join Fabrice Tourre, the Goldman Sachs vice president, who was found liable for misrepresenting the construction of a large mortgage-backed security as mid-level employees charged with securities improprieties. In customary fashion, the supervisors in this saga have avoided culpability.
Rather than write, yet again, about the failure of prosecutors and regulators to go after higher-ups, I want to turn to the subject of prices. Every afternoon you can go online and obtain the value of your mutual funds, just as the senior executives at investment banks can get closing values for their trading portfolios. For example, the PIMCO Total Return (PTRAX), a common holding in 401(K) plans, was priced at $10.66 on August 16th. While the price looks very precise, and you could have bought and sold shares of the fund last Friday based on that price, it is an estimate. PIMCO has extensive policies and procedures, and I’m sure they are very diligent in pricing all the securities in their portfolios. While some of the securities such as US Treasuries, are relatively easy to price, some of the more illiquid bonds and derivative contracts present greater challenges. Hopefully, the $10.66 per share price is an unbiased estimate of the value of the portfolio.
In a large cap equity fund there’s not much guesswork in pricing securities, as the stock exchanges provide a ready market for determining daily values. However, the prices of publicly traded stocks can begin to get a bit fuzzy if the stocks are illiquid and/or the fund has a very large position in the security. Although multiple brokers may be posting prices, the spread between the bid and ask can be large and/or may only indicate a willingness to transact a small number of shares. So while small cap or micro cap funds post their prices with the same two decimal precision as their large cap sisters, there’s a lot more uncertainty in their prices. Moreover, small cap managers may take different approaches to pricing the same stock. One manager might use the mid-point between the bid and ask, and a second manager might take a more conservative approach and use the bid price. Meanwhile, a third manager might apply a “liquidity discount” to the security on the theory that it would sell well below the closing bid if the manager were to have to sell the entire position. Martin-Artajo and Grout should have probably applied a massive liquidity discount to their derivatives positions because some of them were so large they became known in the market as “whales”.
Set out below is an example. Suppose a manager had a 5% position in an illiquid security where the market had large $4 spread. If the manager used the midpoint the fund would have a price of $10.52, while a manager using the bid minus a discount would have a NAV of $10.43. Different approaches to security pricing result in different fund valuations.
Price Fund NAV
Bid 24 10.48
Ask 28 10.56
Mid 26 10.52
Discount 10% 10.43
When portfolios start to consist of various types of esoteric corporate bonds or asset-backed securities, actual brokerage bids may disappear altogether, and portfolios may be priced using “indicative” bids, which are brokerage firm guestimates of where they might be willing to buy or sell. Obviously, prices are getting fuzzier.
We can go a step further into certain kinds of complex derivatives, where the security is so customized that there isn’t any discernible market or even an indicative bid. The only parties pricing the security may be the managers who bought and sold it. Thus the price is only as accurate as the assumptions that they put into their investment models. At this juncture, we’ve moved from prices that are fuzzy to prices that are opaque.
Let’s return to Mssrs. Martin-Artajo and Grout. They made a very large credit derivatives bet on behalf of JP Morgan, and they were wrong. In order to mask their growing losses, they used more and more aggressive pricing policies to hide their losses. When JP Morgan actually decided to unwind their handiwork and expose the position to actual market forces, JPM suffered $6 billion in losses.
Because many aspects of pricing are fuzzy, if not opaque, there are tremendous opportunities to manipulate prices. In the JP Morgan saga, the goal was to hide losses. However, money managers can also be tempted to inflate values in order to overstate gains, and enhance their bonuses. During my career, I’ve seen money managers enter small buy orders for illiquid securities at the end of a quarter, known as “window dressing,” in order to inflate the value of the holdings in their funds and their bonuses. If the security doesn’t trade, brokers can be paid to raise indicative prices (e.g., the LIBOR scandal), or more favorable assumptions can be entered into models.
Adding greater levels of compliance and risk management is Wall Street’s preferred solutions to these improprieties. These steps are helpful but insufficient. At the end of the day, compliance officers are still dependent on traders and portfolio managers for information. Even if risk managers report directly to the CEO, all too often they are kept on a short leash because the CEO doesn’t want to constrain his moneymakers.
Pricing securities isn’t a science. At its best, pricing should be unbiased and conservative. Every money manager and investment-banking executive will swear by these principles. Until they are held personally accountable, their vows of conservatism will not be consistently practiced.