SEC Charges Adviser and Portfolio Manager with Misrepresenting Mutual Fund Risk
One thing that people sometimes like to do is tell other people how safe they and their activities are. People like being told things like that, too. If you’re an investment adviser, though, and those things have to do with how much risk your investments carry, the things have to be true. Catalyst Capital Advisers and Jerry Szilagyi found out the hard way last week when the SEC charged the firm and its CEO with misrepresenting the risk management procedures it had in place in the event of significant market corrections. Another case against an unnamed Senior Portfolio Manager appears to be right around the corner. The allegations below come from the SEC’s administrative order. We don’t know if they’re true.
Allegations – Risk Management Procedures
Once upon a time, in 2013, Catalyst launched the Catalyst Hedged Futures Strategy Fund as an SEC-registered mutual fund after converting it from a private fund that the Senior Portfolio Manager established in 2005. Szilagyi co-founded Catalyst in 2006. The Fund primarily invests in options on S&P 500 index futures contracts.
A central selling point for the Fund was Catalyst’s risk management procedures. In promoting these procedures, Catalyst and the Senior Portfolio Manager said a lot of things in marketing documents and in phone calls. They talked a lot about how they used stop loss measures and triggers to exit positions that would limit the Fund’s losses. Here are some of the things they said:
“Risk Management – Every position is initiated on a hedged basis with portfolio level stop loss trigger points to limit drawdowns.”
“If a drawdown reaches 8% of overall portfolio risk, there is a trigger to exit position(s).”
“[The Fund utilizes a] Risk Management Strategy explicitly focused on limiting losses by hedging individual positions at initiation, ongoing adjustment based on well-defined risk parameters, and aggregate portfolio stop loss measures.”
“We do have a hard stop at 8% where we flatten the portfolio.”
The SEC says, though, that Catalyst actually “had no ‘stop loss’ measures that operated to cap or otherwise limit losses to a given threshold” and that no particular action was mandated at any given loss threshold. Further, they didn’t really follow the procedures they did have in place.
Allegations – Supervision
Szilagyi supervised the Senior Portfolio Manager, though it sounds like they were at least close to partners. But Szilagyi was Catalyst’s majority owner and engaged the Senior Portfolio Manager to manage the Fund day-to-day. He could have fired Senior Portfolio Manager. They talked about the Fund a lot, but the SEC says Senior Portfolio Manager did not manage the Fund the way they were saying out loud. Then things got rough for the Fund in late 2016 and early 2017.
On (or about!) December 9, 2016, the SEC says Szilagyi learned that the Senior Portfolio Manager had exposed the Fund to significant risk of loss. Szilagyi got on the phone with Senior Portfolio Manager and others “to discuss what we can do to immediately reduce risk in the Fund.” Szilagyi basically said, Please do those things. But Szilagyi didn’t follow up to see if Senior Portfolio Manager actually did the things. It wasn’t until January 25, 2017 – after Szilagyi learned that the Fund had lost more than 4% on a day when the S&P “wasn’t even up 1%” that Szilagyi texted the Senior Portfolio Manager to inquire: “What is going on? I thought we agreed to take the exposure down.” We think the teenage equivalent of this is “Bruh.” The Fund breached its written risk parameters during most of the trading days between the December call and January 25. The SEC says Szilagyi’s not taking reasonable steps to confirm whether the Senior Portfolio Manager managed the Fund’s portfolio risk levels as represented.
Violations and Sanctions
The SEC says that as a result of all of this:
Catalyst violated Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-8, and that Szilagyi was a cause of those violations; and
Szilagyi failed to supervise Senior Portfolio Manager within the meaning of Section 203(e)(6) of the Advisers Act.
Catalyst and Szilagyi are censured and are paying disgorgement, prejudgment interest, and civil monetary penalties totaling $10.5 million.
Lessons
If you say you’re going to do a thing, you have to do the thing. Of course, the SEC couldn’t comment on whether any of the vaunted exit triggers or stop-loss measures would have worked effectively. Still, if you tell investors you have an elaborate series of safety nets but you’re basically full speed without a governor, that only works out as long as it works out. Also, if you’re in a supervisory position at an investment adviser, you do have to supervise. Szilagyi and Senior Portfolio Manager might be friends; they’ve certainly known each other for a long time. But if you’re the supervisor, you’re in charge and you have to be sure that your firm’s actions square up with the things you’ve been telling investors. Talk the talk; walk the walk.