CAPE TOWN – The Financial Services Board (FSB) has confirmed to Moneyweb that it is conducting an investigation into the Third Circle MET Target Return Fund, which lost 66% in just two days last December. The scale of the losses appears to be unprecedented in the South African unit trust industry.
The FSB’s deputy executive officer for collective investment schemes, Jurgen Boyd, told Moneyweb that: “The FSB is currently investigating the circumstances that led to the losses. Once that investigation is complete the Registrar will take appropriate action to deal with the matter”.
Boyd’s confirmation will temper industry concerns that the FSB was not acting on the issue, as earlier communication from the regulator had been ambiguous.
Specifically the FSB will have to determine whether the fund was compliant with its mandate and the Collective Investment Schemes Control Act (CISCA), which sets the rules for unit trust portfolios. This will include an analysis of all the positions in the portfolio and the specific trades leading up to and on the days in question.
The FSB’s acknowledgement that it is investigating the fund follows an investigation conducted by Metropolitan Collective Investments (MetCI), the management company under whose license the fund is run. MetCI says that it found no non-compliance, however it has so far refused to release its report on the investigation to anyone other than the FSB or answer any questions about it.
The CEO of MetCI, Mickey Gambale, told Moneyweb on Friday that they are meeting with the FSB this week, after which they may be prepared to discuss their findings.
“Our intent has always been to follow the process correctly,” Gambale said. “We think it’s the right thing to first discuss it with the regulator.”
He acknowledged that there was a conflict in MetCI investigating one of its own funds, and therefore it was up to the FSB to determine what further steps may be necessary.
“The investigation puts forward our side of the case,” Gambale said. “If there is further investigation that is required, then the FSB must investigate.”
All the asset managers that Moneyweb has spoken to have expressed serious concerns about how such extreme losses could have occurred within a unit trust structure. The unanimous view is that it should not be possible to lose so much in such a short space of time.
Specifically, industry participants have pointed out that as far as they are aware there is no asset or combination of assets that lost 66% in the two days in question – 11 and 14 December. The extreme movement in the fund therefore implies that the portfolio must have been geared or leveraged, and that is not permitted in a unit trust.
Moneyweb has also engaged with two independent derivatives experts who have both expressed concerns about the structures that the fund appears to have been employing. To give some idea of the extent of the derivative exposure in the fund, of the 194 positions held in the portfolio at the end of September 2015, 177 were options, futures or warrants.
The derivative experts pointed out that the equity derivatives appear to be structured in a way that the fund will profit irrespective of whether the underlying shares move up or down. This however requires leverage and is therefore disallowed under CISCA.
Specifically, FSB Board Notice 90 of 2014, which regulates what may be included in collective investment scheme (CIS) portfolios, states that managers must ensure that listed or unlisted financial instruments must not be used “to leverage or gear the portfolio and are covered at all times”.
CISCA also does not allow unit trust managers to profit from a falling market. Although the wording of the act itself may be interpreted differently, the spirit of the legislation is that managers should only use financial instruments to hedge against negative movements if they hold the underlying shares.
However the Third Circle MET Target Return Fund did not hold any shares directly. All of its exposure was through its derivative positions.
FSB Board notice 90 states that financial instruments “may only be included for purposes of efficient portfolio management with the aim of reducing risk, or generating capital or income for a portfolio with an acceptable level of risk or to achieve the investment objective of the portfolio”.
All of this also has to be seen in context of fund marketing material that made little mention of the fact that the fund held any derivative positions at all. Until the end of November 2015, the fund fact sheets indicated that nearly 100% of the fund’s assets were in cash.
Although the asset allocation and holdings information do mention derivatives, these are presented as minimal. The fund’s November 2015 fact sheet reflects a 2.21% allocation to equity derivatives.
There have therefore been concerns expressed that the strategy employed by the fund did not match what was either stated or implied on its fact sheets and that they therefore materially misstated the risk inherent in the fund. The fund’s benchmark of cash + 1% is also questionable in this regard as it implies the use of a conservative strategy.
The fund’s mandate also specifically states that it aims to “offer stable, positive returns”, however for 20 of the 38 full months for which this fund has been operating it has either shown gains of greater than 5% or losses of more than -5%. This kind of extreme volatility is exceptional for a unit trust and raises questions around how the fund’s returns can in any way be considered stable.
The industry will be hoping that the FSB will provide clarity on these issues. Investors also need to be reassured that the money that they invest in unit trusts is being managed in understandable and appropriate ways.
It is worth noting that the FSB’s Boyd advised Moneyweb that: “If investors are of the view that a fund has been mismanaged they may refer complaints to the Registrar, but investors also have recourse to the courts. We note that this fund is a third party named funds and accordingly if it appears that investors were wrongly advised in relation to the level of risk contained in the investment then the investors can refer the matter to the FAIS Ombud.”