Karen Bruton
The SEC is now on Karen Bruton’s case because of her shady fee structures. They claim she’s perpetually rolled losses through “scheme trades” since November of 2014. By taking an incentive fee each month despite her failure to make new NAV highs, she violated both her agreements and allegedly defrauded her investors.
It’s interesting how she did it. Between October and December of 2014, Karen took some heavy losses selling her options. But to keep the incentive fees coming in, she organized a sophisticated options roll at the end of each month. This allowed her to still “realize gains” of 1% every month to take fees from, while pushing unrealized losses out to the next month. Month after month the losses continued to snowball while she continued to collect her fees.
Each month began with a huge realized loss. (The SEC reports that these losses now exceed $50 million dollars.) She offset these accrued losses by selling a ton of in-the-money call options on the S&P 500 E-mini futures due to expire at the end of the month. This injected fresh cash into the fund. Just enough so that she could report a small realized gain to investors. That way she could take fees that month too…
But of course there’s no free lunch in trading. You don’t get gains out of nowhere. When these call options expired, yes she had her cash injection (from the option premium), but she was also left with a futures position (due to assignment) that carried a huge unrealized loss.
Here’s where the loss rolling came in. She needed that futures position to stay open until the next month because if she closed it beforehand, that would realize a loss and cancel out the profits from the calls she sold. That means no incentive fees.
So to cover this futures position, she would simultaneously purchase in-the-money call options expiring the following month on the same day she sold those original in-the-money call options. These calls allowed her to offset any gains or losses the futures incurred at the end of the month until the beginning of the next month.
When the second tranche of options expired at the beginning of the next month, her fund finally realized the huge loss again.
The cycle then repeated.
And on top of all this funny business, the redemption practices of the HI Fund were screwy. Basically, investors could withdraw money from the fund without having to take a hit from these perpetually rolled unrealized losses. So people that got out early would get a windfall, while those slow to act would be left holding an empty bag.
The SEC also claims that Karen Bruton did not inform new investors that their investment immediately lost value when entering the fund due to the built up unrealized losses.
This all smells like a classic Ponzi scheme…Pay the old investors with money from the new ones.
