Book Excerpt: Market Bubbles And A Fund Manager’s Pressure To Perform
Excerpted from ‘Ethics in Finance: Case Studies from a Woman’s Life on Wall Street’, by Kara Tan Bhala, with permission from Palgrave Macmillan.
The so-called “buy side” of finance comprises investment management firms such as pension funds, hedge funds, mutual funds, and investment divisions of insurance companies. These institutions manage money for other people. I worked as a buy side equity analyst evaluating Asian stocks at a private bank in New York and then as a senior portfolio manager at a top-five (by assets under management) fund management company.
I was fortunate the Company chose me from hundreds of candidates to start and manage its Far East ex-Japan mutual fund. This portfolio designation sounds fancy, but it simply means the Fund was allowed to only invest in equities of Asian-based companies, except for those companies listed in Japan. Thus, the Fund invested mostly in equities trading in Taiwan, South Korea, Hong Kong, China, Indonesia, Philippines, Singapore, Malaysia, Thailand, Vietnam, India, Sri Lanka, Australia, and New Zealand. I stepped into this investment scene at a fortuitous time. The last decade of the twentieth century was a period in US investment history when American investors became enamored with Asian equities. The Fund was one of the first of its kind: a mutual fund focused on investing in Asian ex-Japan equity markets. When the Fund first opened to new investors in 1992, US$250 million flowed in within one morning, which was a considerable amount at that time. The Company’s management decided to close the fund at $250 million to allow the Fund’s team to fully invest the money over time and after careful consideration, into the markets. Every time we opened the Fund up to investors, hundreds of millions of dollars would flow in within a few hours so that we had to close the Fund again. Subsequently, after a few iterations of this process, the fund grew to be the second-largest Asia ex-Japan fund in the world with over US$1 billion under management.
The Fund also became one of the most high-profile ones in the Company’s stable of mutual funds because of its presence in the emerging markets space, and also because Asian markets were supercharged at that time. In 1993 the Fund was up an unprecedented 87%, the best performing fund since, well, forever. In the same year, Hong Kong’s Hang Seng Index was up 114%, the Philippines Stock Index was up 112%, and Singapore’s Straits Times Stock Index was up (a mere) 46%. Global investors could not get enough exposure to these Asian “Tiger” markets. This sort of extraordinary market performance and greed-inducing returns occur infrequently but not uncommonly in stock markets. Before the Asian Tigers stock markets boom, there was the Japanese asset price bubble or babaru keiki (bubble economy) in which real estate and stock market prices became highly inflated. In the short seven years from 1982 to 1989, Japan’s Nikkei 225 Index went up a breathtaking 385%. After the Asian Tigers boom, the US stock market had its dot-com bubble. In 1999, the peak of this bubble, the Dow Jones Industrial Index went up 25% (it subsequently went down for the next three years), a considerable move for a mature market. These stock market highs reflect periods of “irrational exuberance,” a phrase coined by Alan Greenspan, a former Chair of the US Federal Reserve Board, to mean highly overvalued asset markets, i.e., speculative bubbles.
During these bubbles, investors clamor for the asset that is rising at blistering speed and in seemingly unstoppable fashion. During the Asian stock market bubble, this level of exposure on the Fund, naturally, puts enormous pressure on the people managing the fund and especially on the portfolio manager who has ultimate responsibility. Daily public disclosure of performance, constant monitoring by financial consultants and their clients can loosen a portfolio manager’s moral moorings. Speculative bubbles are, after all, driven by greed, a vice worthy of inclusion in the Seven Deadly Sins. A conversation with a famous football commentator and former NFL quarterback and a chat with an incensed former Governor of a Western state were among some memorable calls I had to field. Each wanted to know why the Fund had declined in performance and when returns would become positive.
At the end of one poorly performing year, I was tempted to “window dress” the portfolio. Mutual funds and portfolio managers use the strategy of window dressing to improve the appearance of a fund’s performance at the end of the year or quarter. It is a technique to dress up the performance of a mutual fund at a particular instance but the longer-term effects on a portfolio are typically negative. Portfolio managers resort to this practice when the fund’s performance is lagging. In this case, window dressing involved putting buy orders without limits on purchase prices, for a number of thinly traded (illiquid) stocks already held in the Fund. These so-called “no limit orders” tend to push up prices of the illiquid stocks thus improving the performance of the same stocks held in the fund. The effect is enhanced if the portfolio holdings happen to be large. If these orders are placed on the last few days of the year, the rise in prices of the same holdings in the fund increase the fund’s net asset value. Engaging in window dressing for year-end measurement purposes artificially pumps up fund performance. Other labels for this practice are, “portfolio pumping,” “leaning for the tape,” and “marking up.” These terms refer to quarter-end and year-end price manipulation on the part of fund managers via the excessive buying of securities they already own.
The idea is that excessive buying on the last day of the year inflates the fund’s closing net asset value, which in turn exaggerates the fund’s performance.
Research provides evidence of portfolio pumping, where both fund NAVs and the share prices of stocks widely held by funds are inflated on quarter-end, and especially on year-end, days. Another recent study finds similar inflation in stocks widely held by hedge funds.
Illiquid shares of small companies are prevalent in emerging markets such as Hong Kong. For example, let’s say the Fund holds three stocks: Johnson Electric, ASM Pacific, and Giordano Holdings. Johnson Electric manufactures micro-motors such as the ones you find in a car’s power steering or in electric fans. ASM Pacific manufactures tools, materials, and machines that make semiconductors. Giordano Holdings is a casual apparel retailer, selling mainly polo shirts, tee shirts, jeans, and shorts. At that time each was a small-cap stock, with low volumes of trading each day. A large order to buy these stocks could push their share prices up considerably. Say I put in orders to buy millions of dollars’ worth of each stock without price limits. I tell my trader to buy as aggressively as possible. These trades, when put through the market, are enough to boost the price of each stock by 10–20% in one day. If all three stocks go up this amount, then the effect on the NAV of the Fund would be significant on the upside. The more stocks are artificially traded up, the higher the NAV of the Fund at the end of the year. This is classic portfolio pumping.
The pressure to perform, the spotlight on the Fund, and perceived high expectations drove me to consider taking this step. As we shall reason in the next section, the act is unethical. It would be hard for a reader or student in the field to discern this assessment by only reading the academic finance literature on this topic. Instead, finance academics focus on the effects and methods used in manipulating prices (lots of statistical modeling involved for “scientific” legitimacy), but not on the ethics of engaging in these practices. In any case, under the pressure to perform, I asked my closest associate in the Fund, a senior research analyst, to put in the orders to buy illiquid shares of a handful of small Hong Kong companies we held in the portfolio.
The no price limit order would reap a significant price hike in those Hong Kong shares.
My colleague looked at me anxiously and questioned if it was necessary to go down this road. I glared at him and getting no reply from me, he left my office.
An hour or so after I instructed my research analyst to put in the buy orders for the handful of illiquid Hong Kong stocks, he returned, closed the door to my office, and sat down. I surmised from his anguished face he was in deep conflict about carrying out my instructions. There was a fear of offending me, his immediate boss, and then there was the moral uneasiness of doing something wrong. As I suggested in Chapter 2, when you feel morally queasy about doing an act, pay attention because there usually is a well-grounded, rational reason for that feeling. Intuition after all, emerges from a split-second decision that comes out of experience and reason. It was clear the research analyst had rehearsed what he was about to say, which was, he had not put in the orders. Window dressing was unnecessary, he was sure we would do better the next year through our own legitimate efforts. His earnestness and concern moved me (not to tears as per Kant). I canceled the Hong Kong orders and foreswore window dressing. The next year, the fund did perform much better.
Lesson learned: surround yourself with good people, listen to them especially if you know they have your best interest at heart and do not allow the pressures of the job to break your moral compass.
Kara Tan Bhala is President and Founder of the Seven Pillars Institute for Global Finance and Ethics, and has been a sell-side equity analyst, a sell-side equity sales person, a buy-side equity analyst, and a portfolio manager.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.