[fc-discuss] Financial Cryptography Update: GP4.1 - Growth and Fraud - Case #1 - Mutual Funds

Fri, 23 Dec 2005 18:38:16 +0000 (GMT)

 Financial Cryptography Update: GP4.1 - Growth and Fraud - Case #1 - Mutual Funds 

                           December 23, 2005

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https://www.financialcryptography.com/mt/archives/000604.html

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As the final part of this rant-in-four-parts, I'd like to leave you
with a view that this is of relatively broad significance, if it works
at all. I attempt this by putting it in context of several case
studies, which are chosen for their breadth as well as their
topicality. In each, I try and draw out some of the implications of
the theory, but I do not especially state when GP is reached. 
Rather, that is left as an exercise for the reader.

First off, the mutual funds scandal, one of the bigger frauds of
recent times. This fraud happened because managers were in control of
assets, but were not compensated as to <a
href="http://hsgac.senate.gov/_files/012704bogle.pdf">how those assets
performed</a>.	Rather, they are compensated according to the total
size of assets. So not only do they have no incentive to perform, they
are incentivised to not do so in a big way. This classical agency
problem is also at the core of the recent Refco collapse. Brief
digression on Refco:

<blockquote>Refco were offering, so the scuttlebut went, a facility to
lose a bad order on demand. It worked this way. A dodgy manager could
place, say, ten good orders into Refco, and then agree with her
counterpart over at Refco to call one of them a bad debt. In a sense,
a pre-ordained fake trade. The insider would then send the money off
somewhere, and the two conspirators would split the profits. 
Meanwhile, the trade would get stuck on Refco's books as a bad debt and
be dealt with some other time, including being traded back and forth
for its tax advantages. Of course, over time this build up of bad debt
would rise to strike, but by then it was someone else's
problem.</blockquote>

So, how does all this happen? I suggest it is a case of post-GP
insider fraud, something I first mused on when writing the <a
href="http://iang.org/papers/mutual_funds.html">testimony</a> given by
Jim before the U.S. Senate's finance subcommittee.

When a mutual fund first starts up it faces large upfront security
costs.	These are similar to those we discussed earlier, but this time
it is more often termed governance, and they are more by regulatory
fiat than the common sense of open governance.	Included are separation
of roles, audits, special purpose entities, accounting systems and best
practices.  We put all these in place before the fund gets off the
ground, and we do it properly and in the best tradition of trying to
make us look squeaky clean.

Add to that, the dramatic attention paid to every new fund! Who is
it? Do they have a track record? Is there room for more funds, more
ideas? Etc etc. Which results that the combined weight of all
this attention both internal and external means that the
security-to-value ratio is very high in the beginning.

Ludicrously high! But over time, much of the hard external scrutiny
disappears as the reputation of the fund grows. New members hear it
from old members, who are very happy with returns. Glowing reports are
purchased from the press and rating agencies, who have nothing to fear
and everything to gain. Insiders get used to believing in their
impeccable reputation, which eventually becomes the axiom to be
stressed, not the result of care and diligence. Brand replaces
skepticism, and observation of the <a
href="http://www.veryard.com/notions/2005/05/bezzle.htm">Bezzle-reducin
g kind</a> is diverted and neutralised.

<center><img src="/images/gp6.png" width="422" height="266"> fig
6. Value Grows as Attention diminishes</center>

And, of course, value under management climbs.	From the first few
millions, some funds reach into the billions.  All the while, as value
grows the internal attention to governance decreases.  Inevitably,
desire for profits means aggressive attention to controlling of costs. 
When directed at governance, a pure cost centre, the inevitable result
is that the security-to-value ratio switches from ludicriously high to
ludicrously low.

Why is it GP-apropos? Because the protection was put in place
before it was needed. By the time it was needed, the protection had
withered away and the fund no longer had the capability to govern
itself.

All the mutual funds that were hit by market timing were older,
established funds.  Their reputation was impeccable, and that should be
seen as a core symptom of the underlying syndrome - when the cat went
away, the mice started to play.

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