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SEC Charges Portfolio Managers With Misleading Investors Over Funds’ Risks

The charges against the executives of LJM Funds Management and LJM Partners claim they failed to inform investors about potential losses. The funds later suffered a $1 billion loss.

Top executives for a set of Chicago-based investment advisors misled investors about the level of risk in their portfolios, the SEC claimed, as the funds later underent “catastrophic trading losses” totaling more than $1 billion during a volatile market period in early 2018.

The commission filed an action demanding a jury trial against LJM Funds Management and LJM Partners, as well as portfolio managers Anthony Caine and Anish Parvataneni. According to the SEC complaint, the firm had a “short volatility” trading strategy, which offered the potential for high returns, but left a chance for higher losses.

This left investors in the funds worried about how LJM would manage this risk, questioning what they might lose “during an extreme market event.” Caine and Parvataneni allegedly responded to investors’ concerns by claiming they stress-tested portfolios against historic scenarios (including the 2008 market crash) to estimate the potential worst-case scenario for daily losses, and found those worst-case scenarios ranged from 20% in losses on certain funds to as high as 30% to 35% on other funds. According to the SEC, the fund managers told investors those risks were offset.

But these were false statements, the SEC asserted. While the funds did generate historical scenario stress tests each trading day, the company did not use them to estimate what the worst potential losses could be. The 20% figure came from the portfolio managers taking the fund’s worst performance on a single day (at 9%), doubling it, and rounding up to 20%, according to the complaint. 

“Moreover, on nearly every trading day from late 2016 through early 2018, the historical scenarios stress test LJM purportedly used to estimate ‘worse-case’ losses showed potential losses greater than the worst-case daily loss estimates disclosed to investors,” the complaint read. “In fact, on many occasions, defendants’ stress testing estimated potential loss exposure approaching or exceeding 100% of the funds’ value.”

Starting in 2017 and into the early months of 2018, Caine and Parvataneni actually increased the risk level in their portfolio in order to match their return targets. The increase in risk for investors didn’t go unnoticed by the executives, with Caine allegedly writing in one email in late 2017 that he was “a bit scared of the main portfolios,” and that they had “a directional bias.”

In a statement responding to the SEC complaint, Caine said that they "categorically deny" the assertions from the SEC (as well as a Commodity Futures Trading Commission complaint filed at the same time), and that they will be rejecting settlement offers and will "vigorously defend" themselves against the charges. Instead, Caine argued the losses were due to a massive single-day increase in the VIX Index, which he said doubled the previous largest single-day move.

"We will demonstrate that risk of loss was fully disclosed, LJM did not deviate from historic portfolio and risk management practices, and the losses sustained on February 5-6, 2018, occurred as a result of events outside of LJM’s control," Caine said. “The suggestion that LJM committed fraud has no factual basis and is undermined by the fact that I personally lost over $100 million on February 5-6, 2018, and LJM portfolio managers invested more than $500,000 new capital on February 1, 2018, in the same funds as LJM investors." 

Additionally, Caine said it was "highly ironic" that the SEC and CFTC were pursuing claims against LJM, which he said was harmed by the regulators' failure to overee the markets.

According to the SEC's complaint, Parvataneni came to Caine with a plan to make trades that would reduce the risk levels, but it would mean the funds would book losses that LJM would not make back during the first quarter of the year. 

“Caine rejected this course of action and instead decided that LJM would continue to carry increased risk levels in the LJM portfolios in order to give LJM a chance to have positive earnings for Q1 2018,” the complaint read.

In February 2018, market volatility roared back, with the S&P 500 Index falling more than 6% in two days. LJM funds took on trading losses exceeding $1 billion, or about 80% of their total value, leading to a “total collapse and liquidation” of the funds, according to the SEC. On Feb. 7, the fund closed to new investors, and by the end of March, it was liquidated and dissolved. At the time, it was among the most significant funds to “fall victim to the popular ‘short vol trade,’” according to CNBC.

But the trading had been profitable for the executives, the SEC claimed. LJM Management’s advisory fees grew 400% between 2015 and 2017, with Parvataneni benefitting from bonuses exceeding $3 million in two years. Caine received distributions of the funds exceeding $15 million in 2017 and 2018, and even extracted more than $5 million from the company after the massive losses in February 2018, according to the complaint.

The SEC is seeking permanent injunctions for the defendants, as well as disgorgement and civil penalties. It also announced it had settled charges against Arjuna Ariathurai, who served as JLM’s Chief Risk Officer. Without admitting or denying the charges, Ariathurai agreed to a bar with a chance to reapply after three years, as well as disgorgement and prejudgment interest of $97,444 and a civil penalty of $150,000.

Earlier this year, FINRA censured Securities America, Cambridge Investment Research and J.W. Cole Financial, arguing they failed to supervise representatives recommending that clients invest in LJM funds. Cambridge reps urged investors to purchase more than $18 million from the funds (80% of which came from a single buyer); J.W. Cole sold about $1 million and Securities America sold more than $616,000 in total, according to the regulatory agency.

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