(Morning Star) - On the Run
In the 2019 film “Uncut Gems,” Adam Sandler’s character lost complex parlay bets on NBA games, pretended to outsiders that the truth was otherwise, and scrambled to stay one step ahead of debt collectors.
In the 2019 mutual fund Infinity Q Diversified Alpha, portfolio manager James Velissaris lost complex parlay bets on the financial markets, pretended to outsiders that the truth was otherwise, and scrambled to stay one step of accountants and lawyers.
Life imitates Hollywood. Velissaris’ adversaries were less colorful than the Armenian gangsters of the film, and they dispatched gentler justice. But eventually they, too, caught their man. Last February, as discussed in “Infinity Q: The Fund that Checked All the Wrong Boxes,” the SEC made an offer that Infinity Q’s board of directors could not refuse. It promptly fired Velissaris and closed the fund. It was to liquidate its assets, distributing the proceeds to shareholders.
More Bad News
When the fund shut its doors, it was up slightly for that year to date. However, the SEC’s statement signified that performance would not stay that way. The Commission had learned that the fund’s “Level 3 assets”--that is, its custom derivatives, for which no public market existed--were overvalued. As such assets made up 18% of the fund's portfolio, a significant write-down appeared to await. Perhaps management would only receive 75 cents for each stated dollar, thereby reducing the fund’s net asset value by 4.5%.
Then again, the effect could prove considerably larger. Including its sibling hedge fund, which invested similarly, Infinity Q Diversified Alpha controlled $3 billion. Dropping that much money into an illiquid marketplace would likely depress prices. By the time all was said and done, Infinity Q Diversified Alpha might shed 10% from its net asset value. Besides being frozen out of their accounts, the fund’s shareholders would become involuntary tithers.
At least, that is what I initially thought. But then another shoe dropped. On March 11, three weeks after its initial disclosure, Infinity Q shared the happy news that it had disposed of nearly all its holdings, with 93% of its assets resting in cash. This was accompanied by the less happy, if predictable, news that its securities had been sold for something less than their stated values. In addition, the fund would need to establish a reserve, of an unspecified amount, to defray future “costs and liabilities.” Those monies would come from shareholders’ pockets.
Hmmm. This was followed two weeks later by an announcement that provided the actual numbers. On Feb. 18, 2021, the final trading day before the fund was shuttered, the publicly available version of Infinity Q Diversified Alpha was officially valued at $1.73 billion. Regrettably, management stated, those securities had fetched only $1.29 billion when sold. Rather than 10%, the markdown had been 25%!
A Simpler Reason
That struck me as a particularly graphic example of the damage that can ensue from investment fire sales. Put $10 million of Microsoft (MSFT) shares up for bid, and the marketplace won’t blink. But try to move $10 million of a custom-build “variance” derivative, however, and buyers may react. A plausible hypothesis, but wrong. The main explanation for the gap between this fund’s stated and actual values was more basic: The SEC alleges that its portfolio manager had invented its holdings’ prices.
In last week’s 65-page complaint, the SEC describes behavior that might have embarrassed even Sandler’s character. According to the commission, Velissaris used every trick in the book to prop up the fund’s value--as well as a few unwritten dodges. Being customized, most of the fund’s investments were priced with a computer program. Velissaris had that program singing like a canary. He selected inappropriate models and implausible volatility estimates. He lied about his investments’ features. Sometimes, he even hacked the model’s code.
Because the computer program was provided by an outside company, it was independent--in theory. In practice, though, it was anything but. Even if Velissaris had lacked the ability overwrite the program’s code, he could still control its inputs. It seems, per the SEC’s account, that nobody stood in his way. Not the pricing service, not Infinity Q’s compliance department, not the fund’s auditors, not the board of directors. What Velissaris wanted, he did.
Although--and this is where the “Uncut Gems” comparison becomes vivid--doing so sometimes required fancy footwork. For example, on Sept. 18, 2020, Velissaris was informed that the fund’s auditor wished to verify the price of one of the fund’s holdings. According to the SEC's complaint, Velissaris altered the security’s term sheet, forwarding the auditor a forged version of the original contract.
Watch Your Step!
The investment lessons from this debacle are straightforward.
- Avoid the exotic. Such deception could only arise at a fund that holds esoteric investments. Any security that trades reasonably often, such as stocks, investment-grade bonds, and off-the-shelf derivatives, would be priced through trade data, rather than by using a model, and would therefore resist such manipulation.
- Beware big promises. No fund ever boasted more loudly than did Infinity Q Diversified Alpha. It would succeed in bull markets, in bear markets, in flat markets. Those fortunate enough to own the fund would enjoy “access to the top tier investment strategies typically reserved for elite high net worth clients.” Translation: Hold your wallet, carefully, while walking backward.
- Be wary of owner-operators. No major fund company, in my view, would have given Velissaris as much rope as did Infinity Q. Big-company portfolio managers have supervisors, risk controls, and compliance officers who hold the authority to overrule them. As an owner-operator, Velissaris faced no such constraints.
Also, in the unlikely event that a leading fund company oversaw a similar disaster, it would compensate shareholders for their losses. Mostly likely voluntarily, to preserve the organization’s reputation, but if not by choice, then through an SEC mandate. Infinity Q’s shareholders will almost surely foot the bill here.
By John Rekenthaler
John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
