Financial Ethics 101: Portfolio Pumping

By: Advaita Sehgal
Financial Ethics 101-Portfolio Pumping

Part of SPI’s Financial Ethics 101 Series

I. Introduction

Portfolio pumping is an illegal trading practice which artificially inflates an investment portfolio’s performance. It impacts reported performance and has benefits to investment managers by making a fund look attractive at the expense of investors and market integrity (Fernando, 2022).

Various studies (Patel and Sarkissian, 2020) show portfolio pumping happens when fund managers place huge orders on their own holdings. This temporary increase in fund returns on the last day of the financial year (or quarter) usually reverses on the first day of the next year. The SEC must prove trading was done with the intent to manipulate returns. These events and the reversal of returns proves to be circumstantial and indirect evidence. The amount of inflation of prices varies between 0.5% per year for large cap funds to around 2% for small cap funds (Carhart et al., 2002).

II. Mechanics of Portfolio Pumping

Impact on Portfolio Value and Investor Perception

These trading activities have an immediate effect on Net Asset Value (NAV). NAVs per share are usually calculated from closing prices of holdings. Portfolio pumping hence results in abnormally high NAVs at year-end or quarter-end. These misleading performance metrics impact long-term investors.

Causation and Hypotheses 

In portfolio pumping two hypotheses have been extensively studied, the first being the benchmark-beating hypothesis, and the second, the leaning-for-the-tape hypothesis. These hypotheses attempt to explain abnormal patterns in fund returns especially around quarter-end dates.

  • Benchmark-Beating Hypothesis

This hypothesis posits managers who perform below a benchmark such as S&P 500, engage in marking up portfolio values to surpass these benchmarks. Their incentive is to present an image of outperforming the market. This manufactured outperformance attracts more investors and enhances the manager’s reputation, along with their compensation. 

However, research by Carhart et al. (2002) gives compelling evidence that disparages this hypothesis. If fund managers were always trying to beat such benchmarks, then there would be an empirical distortion of data with concentration of returns closely around these benchmarks. For example, if funds were manipulated to beat the S&P 500, then there would be distribution of returns with concentration of funds slightly above the benchmark. However, this is not the case and hence the hypothesis does not hold. 

  • Leaning-for-the-Tape Hypothesis

This hypothesis states that fund managers of the best-performing funds mark up their portfolios to improve their year-end rankings. This is due to the convexity of the flow/performance relationship, where higher rankings result in disproportionate inflows of capital which in turn results in higher managerial incentive pay. This hypothesis, unlike the one above, finds substantial support in the findings of Carhart et al. (2002). The year’s top-performing funds show significant abnormal return reversals at year-end. The same consistent pattern was seen at quarters too, in a small trading window at their end.

Therefore, while the benchmark-beating hypothesis lacks empirical evidence, the leaning-for-the-tape hypothesis explains the abnormal return patterns observed around quarter-end dates, especially among top-performing funds. 

When looking at mutual funds, specifically, it can also be seen that family-level portfolio pumping results in huge profits for firms (Wang, 2024). This is because the profits of a mutual fund family derive from total assets managed and their fees. Inflating returns of star funds in this case leads to increased returns for those funds, but also for the non-star funds in the family as profit spills over. This leads to increased fund family size, thereby benefitting non-star fund managers since asset size determines their compensation. The shift to fund family-level pumping from fund-level pumping leads to greater difficulty in detection by regulatory agencies as it is subtler in nature. 

III. Statutes and Regulations

The Investment Advisers Act of 1940 (U.S. Securities and Exchange Commission, 2020) is one of the primary legislations governing the conduct of investment advisors. This act was created to protect investors. Portfolio pumping, though not directly mentioned, is in direct opposition to the prohibition against fraudulent practices and fiduciary duties outlined. This forms a strong basis for legal action against fund managers who engage in such practices.

The Securities Exchange Act of 1934 is another law that addresses market manipulation more broadly, by prohibiting deceit and fraud in connection to purchases/sales of securities. Portfolio pumping hence falls in the purview of this Act making it subject to actions and enforcement by the SEC.

Therefore, enforcement of such laws by the SEC is critical in deterring portfolio pumping, as legal action against fund managers includes fines, suspension, or revocation of their registrations. However, since portfolio pumping involves subtle manipulations, they are hard to distinguish from regular market trading and require in-depth monitoring and analysis.  Recent developments to aid the SEC include advancements in big data and advanced analytics. These technologies help detect portfolio pumping patterns of trading even if they are spread across accounts over extended periods of time.

IV. Case Analysis of Portfolio Pumping

A notable example of portfolio pumping was in a Minneapolis-based hedge fund – Archer Advisors LLC (U.S. Securities and Exchange Commission, 2014). The SEC charged the firm’s owner, Steven R. Markusen, and Jay C. Cope, his employee, with conspiracy to manipulate stock prices of the largest holding of the firm – CyberOptics Corp. (CYBE).  This had detrimental effects on investors. They maintained and even increased their investments since they had been deceived into believing the hedge fund was performing well. When the true value of the fund became apparent, investors faced huge losses. The market was also significantly affected as CYBE’s stock price led to inefficiency and mispricing. This impacted other investors too as they relied on CYBE’s stock as a market indicator. Along with placing large buy orders “marking the close” 28 times on the last trading day (Fernando, 2022), Markusen and Cope diverted soft dollars from third-party research and disguised them as research fees to pay Cope’s salary. This further compounded the deception. 

  • Analysis of the Ethical Failings in the Case

The ethical failings here are stark. The fund managers engaged in deceptive practices by prioritising their financial gain over their duty to serve their clients’ best interests. This conduct constitutes a fundamental ethical failure as an act, as it breaches fiduciary duty. It also harms as it leads to significant financial losses for investors who trust the accuracy of reported returns. 

In the case of Archer Advisors, a significant conflict of interest should be noted. Markusen and Cope’s manipulation goes beyond just inflating the value of portfolios. Price inflation also helped them extract higher management fees directly tied to inflated values. Hence, their actions show clear prioritisation of selfish gains over ethical responsibilities to manage funds with integrity. In the long term, affected investors also become more sceptical and cautious, which leads to less participation in markets and lower overall liquidity which harms the economy as a whole. Such cases serve as a reminder of the importance of ethical conduct in investment management and emphasise greater transparency and a commitment to investors’ best interests. 

V. Ethical Analysis

The manipulation and deception which takes place due to portfolio pumping violates the trust between investors and fund managers along with compromising ethical duties and transparency investment professionals owe to clients. These ethical concerns are significant, since they mislead investors who rely on reported returns to make informed decisions about finances. 

  • Moral Responsibility

At a first glance it is apparent that at any instance of portfolio pumping, the moral responsibility lies primarily with fund managers who manipulate stock prices or fund returns. The manipulation also relates to their specific contracts. A study by Li and Wu (2019) in China shows stronger pumping of funds is done by managers’ who are on performance-based compensation contracts. This unethical act is not due to the innate immorality of humans. Since performance of these funds is highly volatile, they cannot actively cherry-pick contracts which match their “manipulative disposition”. Fund managers take these decisions to pump after observing their contract. They act as moral agents and are directly responsible for decisions to engage in portfolio pumping with various harms as discussed above. 

There exists a broader collective responsibility here too. This includes the brokers, the firms employing these managers, and even regulatory bodies. The firms are morally responsible to ensure their employees adhere to moral standards. They must employ strict compliance programmes and take strict action against unethical behaviour. When they fail to do this, they too are responsible for unethical practices like portfolio pumping employees engage in. Brokers executing trades also bear responsibility, even though they are not the main decision makers. They act as facilitators of the portfolio pumping trades, and hence should be aware they are morally complicit in market manipulation activities. Hence, they should not blindly go forward with these trades but instead become whistle-blowers if they believe malpractice is taking place. Otherwise, they too bear moral responsibility in part for the actions. Failures in regulation and law enforcement can indirectly contribute to unethical practices. Agencies like the SEC need to monitor and penalise such practices to protect investors

  • Impact on Market Integrity

Portfolio pumping also has consequences for the integrity and the basis on which financial markets are created. The integrity of these markets is predicated on the principle that people will have access to accurate and reliable information to make informed decisions. This transparency ensures the most productive and efficient use of capital, essential for a well-functioning economy. Manipulation of metrics through inflation of fund performance undermines this foundational principle. Misleading investors directs their investments into funds which appear to be well-performing, even though they are underperforming. This distortion of market signals leads to a ripple effect on inefficiencies in capital allocation.  

These activities may also lead to increased regulation and intervention in the market. Regulation is necessary to maintain market integrity, however excessive intervention stifles market innovation and competitiveness.

Application of Ethical Theories

  • Kantian Ethical Analysis

Kant’s categorical imperative – which requires that actions must be universally applicable and that individuals should be treated as ends in themselves. According to Kant it is morally wrong to treat persons as means i.e., regard them, 

“As a mere instrument or tool: someone whose well-being and moral claims we ignore, and whom we would treat in whatever ways would best achieve our aims.” (Kerstein, 2019)

This can be clearly applied to the practice of portfolio pumping since it fails to treat investors as ends in themselves, and if the practice of inflating portfolios was universally applied, it would damage the fabric of investment management and lead to widespread mistrust. Therefore, this failure to respect the autonomy and dignity of investors sheds light on the unethical nature of portfolio pumping from a Kantian perspective.

  • Utilitarian Analysis: 

Utilitarianism (Mill, 1879) has its basis in maximising overall well-being or happiness for the greatest number of people. Consequences therefore become the framework to judge the ethics of actions. From this perspective, the ethics of portfolio pumping can be evaluated by weighing overall harms to investors and markets against benefits gained by the fund managers and firms. This analysis clearly indicates that overall harm caused by portfolio pumping to market integrity as highlighted earlier outweighs benefits. This is because harms are widespread to investors and in the form of reduced trust in financial markets. Distorted asset prices lead to even greater economic harm. The benefits on the other hand are financial rewards concentrated in the hands of a few. Hence, from a utilitarian point of view portfolio pumping is ethically unjustifiable. 

VII. Conclusion

Analysing the various facets of portfolio pumping lead to understanding its deep ethical challenges within the investment management industry. Artificially inflating fund performance deceives investors and undermines integrity of the market. The consequences of this are far-reaching as they impact the functioning of the economy along with investors. 

Improving ethical practices in the industry requires a great deal of transparency and honesty. Managers must commit to complete transparency in their reports of fund performance and accurately represent the true value of portfolios to avoid practices that could artificially inflate results even beyond portfolio pumping. Honestly communicating with investors is vital to foster trust and ensure they make decisions based on accurate information. 

Investor protection is also crucial to protect investor interests. Adhering legal standards while also going beyond compliance to ensure long-term benefits of investors is necessary. Internal controls should be implemented to detect and prevent conflicts of interest. Firms must create such a culture of integrity. The likelihood of unscrupulous practices like portfolio pumping occurring can be reduced in an environment where ethical behaviour is the norm. Developing a zero-tolerance policy for ethical misconduct and having regular ethics training are a few steps that can be taken to ensure this. Managers must lead by example and take responsibility for their actions, prioritising investor well-being rather than corporate and personal gain. A culture of integrity ensures stakeholders – fund managers, brokers, and investors – are aligned in their commitment to ethics. 

The investment management industry will only prosper once financial goals are balanced with a strong commitment to ethical principles. The industry can restore and maintain the trust of its investors by prioritising values of transparency, accountability, investor protection and integrity. This ensures that pursuits of profit align with societal well-being. Striking this balance is essential for the long-term sustainability of the industry and the financial markets it forms a part of.

References

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