The $128 million index arbitrage loss suffered by The Common Fund frightens institutional investors.
Pension fund executives fear they are more vulnerable to risk and potential fraud than they had thought, their consultants say. And, they wonder how they should monitor the privately negotiated investment agreements they increasingly are using.
Their greatest concern: How one trader at First Capital Strategists Inc. allegedly was able to keep a loss undetected from any internal or external controls for three years.
The incident is "incredible," said Stephen Nesbitt, senior vice president with the pension consulting firm Wilshire Associates, Santa Monica, Calif.
Ron Peyton, president of Callan Associates Inc., San Francisco, predicts pension fund executives will be trying to strengthen controls over their assets following the index arbitrage loss at The Common Fund, Westport, Conn. He said the incident has further splintered trust in the investment community.
Although it was on a much larger scale, some likened The Common Fund loss to the Barings PLC incident, where one trader hid losses of $1 billion. In the Barings case, however, the losses were sustained by a bank; in The Common Fund case, pension investors are more concerned because the losses were sustained by a high-profile member of the institutional investor community that manages money for hundreds of university endowments.
According to a statement from officials at First Capital, based in York, Pa., trader Kent Ahrens "admitted to having failed to fully hedge an index arbitrage trade effected on behalf of The Common Fund in 1992." Over the next few years, he was unable to trade out of what was at first a "relatively small loss," the statement said.
Mr. Nesbitt said he is "astounded" none of the controls seemed to work in detecting the problem. He said such gaps in monitoring systems could be more widespread than previously recognized.
"There is a glitch in the system somewhere for this to have happened to The Common Fund. There has got to be a crack in the system. We have got to find out how this crack occurs and we have got to fill it," he said.
Said Callan's Mr. Peyton: As long as money managers "allow a trader to make the trades and then report on their own trading without anybody else double-checking or reconciling it, these things are going to happen."
Mr. Peyton said the current first line of defense for pension funds is for money managers to have financial controls and dual-checking methods. But he suspects many money managers don't have those controls and checks.
The second line of defense, said Mr. Peyton, will be for custodians to develop the tools necessary to determine the true risk exposures of pension funds, as well as money managers' compliance with investment guidelines.
Many of those tools haven't yet been developed, he said, and it will be a "huge undertaking" for the custodians to develop them.
Early information indicates the fund's loss involved a private swap transaction that was part of an arbitrage strategy, said Mr. Nesbitt. He noted institutional investors increasingly are using more privately negotiated agreements, which makes finding protections against losses suffered by The Common Fund more urgent.
One key question, Mr. Nesbitt said, is: "Under what circumstances can a manager who has been delegated authority enter into a private transaction that is not picked up by the custodian?"
One reason a custodian might not have detected a problem was that no cash was passed in the transaction, Mr. Nesbitt said. Still, he doesn't understand why a problem wasn't detected over a three-year period when there would have been intermittent cash settlements.
"What concerns me is that I thought any transaction has to be fully accounted for by the custodian," said Mr. Nesbitt.
But Michael Costa, a principal with MLC Associates, Putnam Valley, N.Y., a consulting firm specializing in global custody, master trust and fiduciary services, said, "I wouldn't think it would be the responsibility of the custodian to monitor a third-party lender." He added the custodian might have certain reporting responsibilities.
Mr. Costa said he would have to look at the agreement between The Common Fund and its custodians before he could understand the custodians' responsibilities and the relationship between the custodians and the fund.
Custodians for The Common Fund are Mellon Trust, Pittsburgh, and First Trust, Minneapolis.
A spokesman for The Common Fund said officials are "in the early stages" of determining what happened. An investigation will look at each player's role, including the custodians, he said.
Jonathan Hubbard, corporate spokesman for Mellon, said: "As custodian, we are required to follow the investment instructions given to us by our clients' investment managers. In addition, with the information available to us, we weren't in a position to monitor First Capital's compliance with its contractual obligations to The Common Fund."
First Trust officials could not be reached for comment.
Pointing to another issue, Mr. Nesbitt said, "It's incredible to me, absolutely astounding, that a small outfit (First Capital) cannot know its own positions."
First Capital officials declined to comment.
A chief investment officer for a major educational institution who didn't want to be identified, said the type of loss suffered by The Common Fund might depend on its securities lending investment collateral guidelines and how closely those guidelines were monitored. The institution does not deal with The Common Fund.
According to one source familiar with The Common Fund situation, officials there thought First Capital was using a very conservative, low-risk arbitrage strategy that provided modest returns. At the end of the day, the index arbitrage transactions made for The Common Fund were to be market neutral.
At the end of every month, the fund was looking at the profit and loss statements on those transactions. But what wasn't being looked at on a microscopic level, the source said, was each individual leg of the transaction.
What the fund is doing now, the source said, is having its lawyers and accountants check each individual transaction that was made by the investment manager, a much more costly cross-check process.
There are ways to prevent or catch the actions of rogue traders at money management operations, but they "tend to be expensive and time-consuming to do," said Tom Lopez, chief investment officer for the $5.8 billion Los Angeles Fire and Police Retirement System.
At the Los Angeles fund, most accounts are "transparent," he said, "making it easy to know what is going on" by looking at the data. Still, problems can crop up even with the more traditional stock and bond investments when a pension fund staff's attention is diverted.
However, he said, some other pension funds do have relationships with money managers that invest in more sophisticated and less transparent investments that aren't traded on major exchanges or for investments that aren't marked to market frequently.
The problem for those pension funds, said Mr. Lopez, is that safeguards aren't always set up because of higher costs involved.
Sometimes, he said, there is a willingness to invest in new investments but not spend money on monitoring of those investments.
Callan's Mr. Peyton held similar views. Mr. Peyton said pension funds should be willing to do more monitoring because it is cheap in comparison to the costs involved when something goes wrong.
As of July 6, a spokesman for The Common Fund said only the University of Minnesota had pulled out of The Common Fund.
According to a statement from Roger Paschke, treasurer and associate vice president for finance with the school, the university reassigned its assets - stock index funds and securities lending - until the loss situation is clarified. Officials said the university, which had what it called temporary investment assets but not endowment money with The Common Fund, wasn't affected by The Common Fund loss.
The Common Fund spokesman added many other clients expressed support for the fund.