The Securities and Exchange Commission has used what it describes as ‘sophisticated analytical tools’ to ‘ferret out’ a Miami-based RIA’s alleged cherry-picking scheme.
The SEC alleged in a complaint filed this week that UCB Financial Advisers and UCB Financial Services Limited, and UCB Group executive director Ramiro Sugranes, have run a cherry-picking scheme since September of 2015, funneling $4.6m in profitable trades to two accounts believed to be held by Sugranes’ parents, who are living in Nicaragua. Unprofitable trades were allegedly directed to dozens of other client accounts to the tune of a combined $5m or more in losses. At least two ‘non-preferred’ accounts sustained more than $1m each in first-day losses.
The SEC has filed fraud charges against Sugranes and frozen the assets of both UCB entities. It seeks to return the ill-gotten gains from the ‘preferred’ account holders to the ‘non-preferred’ investors, as well as strike Sugranes and UCB with permanent injunctions. Sugranes’ parents are named as relief defendants.
Cherry-picking is an illicit way for investment managers to choose which client accounts receive profitable trades and which receive unprofitable trades. The manager uses an average price account to trade stocks and in some cases options, but rather than allocating trades to certain accounts before executing them, they wait until after. By seeing how trades play out before allocation, they can choose to send profitable ones to ‘preferred’ accounts and losing ones to ‘non-preferred’ accounts.
But how does the SEC actually catch cherry-pickers?
In Sugranes’ case, the SEC’s investigation was sparked by the market abuse unit’s analysis and detection center, which ‘uses data analysis tools to detect suspicious patterns, including improbably successful trading,’ according to a statement from the SEC.
An expert dissertation included in the Sugranes case’s court docket offers a clue to how the SEC confirms suspicions of cherry-picking, which can be raised by the SEC’s own monitoring or by a tip or complaint from a customer or custodian.
In this case, the SEC asked Dr. Erin Smith, a financial economist with the risk analysis division of the Office of Litigation Economics, to assess whether the results of Sugranes’ trading activity could reasonably occur for any reason other than cherry-picking.
According to Smith’s analysis, 95 percent of the 2,006 stock and options trades allocated to preferred client accounts were profitable. Meanwhile, 63 percent of the 2,566 trades allocated to non-preferred accounts were unprofitable. First day returns show growth of 0.57% per day for preferred accounts and -0.75% per day for non-preferred accounts. For the preferred accounts, if that first day return was extended to an annual basis, portfolios would double in value every six months. The curve is steeper in the opposite direction for non-preferred accounts.
To rule out random chance, Smith performed a t-test to measure return variability.
‘The conventional threshold for statistical significance is a less-than-5% chance that random chance could generate the observed difference, which corresponds to a t-statistic above 1.96 or below -1.96. The t-statistic associated with the difference between allocations to preferred versus non-preferred accounts is 27.5,’ her dissertation states.
A t-statistic of 6.1 corresponds to a one-in-a-billion chance, so that puts the odds that random chance could account for the disparity at less than one in four billion.
Additionally, 99 percent of the trades allocated to preferred client accounts were day trades – positions that had been closed prior to allocation and had locked in realized profits. Non-preferred accounts received 99 percent of remaining trades that were not closed by the end of the day. These trades had a win rate of just 28 percent.
‘The materials I reviewed… provide strong support that during the relevant period the UCB entities used this account to engage in cherry-picking,’ Smith concluded. ‘I have not identified any evidence that skill, or different trading strategies, or a combination of the two, could explain the observed performance differences.’
According to veteran securities attorney Bill Singer, cherry picking can be straightforward to identify in hindsight, but ‘easily runs under the radar in the absence of a tip or a customer complaint.’
This isn’t the first time Sugranes has been accused of financial misconduct pertaining to a family member. The SEC’s complaint notes that in 2004, Sugranes resigned from a broker-dealer job ‘after he failed to follow company procedures concerning the documentation of certain transactions in one of his relative’s accounts.’
This article originally appeared on CityWire.
