The SEC allege that she and her fund is concealed losses.
I concur with a Radjamax an option trader analysis:-
The real story here is very simple, and many of you are pretty much on point. Here is a rundown of what happened
1. When Karen started the fund, her lawyer gave her different ways of accounting for the profit and loss. The first one is the NAV which accounts for both realized and realized p/l and is done monthly. This is a typical method for actively traded funds with liquid/easy to value investments (equities, options, futures etc). However, there IS a downside to this method. What happens at end of year for tax accounting is that the taxable income is based ONLY on realized p/l (unless you elect a mark to market approach for taxes which is a complete mess tax-wise). So it can create some “unclean” accounting because at the end of the year, the TAXABLE profit will not equal the actual profit to the investor. Karen, being a CPA did not like this so she chose the 2nd method.
2. The method Karen chose is the realized gain/loss accounting. This is actually very common in hedge fund also, but more so with those that invest in illiquid investments. For example, many VC funds do this because their investments in companies (think Uber for example), do not really generate a true profit until they sell the investment (IPO or acquisition). And it would not make sense for investors to pay tax year after year on some phantom gains without actually receiving any money. So the method Karen chose was not wrong or illegal in any way. It was just not really the most common or appropriate method for a liquid market based fund (because there is no reason to not use the NAV based p/l in her case).
3. It’s important to remember that under normal circumstances, regardless of whether a fund uses the NAV method of the realized p/l method, the end result to the investor SHOULD be the same. Especially in her case, trading options with less than 60 DTE, any unrealized losses would normally soon become realized as those positions are closed and/or expire. So at the outset, and for many years, this did not present any real problems. In fact, as you can see by the 2013 CFTC complaint, they audited Karen and made her show the unrealized p/l on her statements yet did not pursue any other enforcement action. In that consent order it specifically said that it was fine for her to use that method, BUT she also needed to let her investors know what the carried unrealized p/l is to comply with full disclosure of performance. That is very telling as of course if the method she was using was illegal or flat out wrong, she would have been shut down at that audit.
4. What happened in October is very simple. Unfortunately, the market had been moving up, and as you all know the adjustments to the call side being tested can and do include selling puts also. This works effectively if the volatility stays low and market keeps moving up or flattens out. But where you run into trouble is when this upward moving market suddenly dips with a big vol increase, which is exactly what happened with the Oct 2014 dip. So now Karen had sold many puts at low vol in an up market, and they suddenly generated significant paper losses. In retrospect, it’s clear that Karen did not have adequate risk management in place and you are spot on regarding her not stress testing her position with a vol increase in Analyze tab. Quite frankly that’s a rookie mistake. Remember too that the Karen strategy works LEAST well in up-trending markets and having grown her fund to a large size, she was under pressure from investors to beef up returns (since 2012, 2013 and 2014 were big up years in the market she was basically not generating any alpha i.e not outperforming the market). So this caused her to take on larger positions than what she was doing in the past. This is pretty common actually. The two most commonly cited “blow ups” of Karen-esque funds (LTCM and Victor Neiderhoffer) suffered the same issue because they became very big, were under pressure to generate profits that was harder to do with the larger size, and started to deviate from their core strategy. Same thing happened here.
5. When the big unrealized losses in October appeared, Karen was faced for the first time with the prospect of no fees coming in. This was also a mistake in how the fund was set up because she should have been charging a base management fee (2%) that would cover her expenses during any down months. However, because her fee structure was incentive only she could not do that. Therefore, knowing full well how her incentive fee structure was based on realized gains, she engaged in trades that created gains for the month to generate fees. Again, this was not done out of malice or profiteering. Because the idea was that it was temporary since the unrealized losses would be made back. From her perspective, it was incentive fees that would have been charged later anyway, so she was just “spreading them out” and pulling in money to pay her traders, staff etc.
6. Where things started to fall apart is because these trades took up margin and also had a slippage/tx cost, it started to eat into her profits and prevented her from executing her strategy properly. This is known as “going on tilt” and is common also for many traders. You have a good plan, but once you deviate and things start to fall apart you can’t get back on track.
7. As of right now there is about $50 mil in unrealized losses, the fund has not blown up, it is not doing well but it’s not a Ponzi scheme and it will continue to trade. Unfortunately, due to the bad press it’s likely that many investors will leave and Karen will end up managing her own money only. There will not be any jail time as nothing criminal was done.
8. One last thing. The redemption issue that was brought up is really the only big problem here. That is absolutely unexcusable and the attorney that drew up those documents honestly is incompetent because that method of redemption is completely inappropriate (those funds that do use realized p/l for accounting have a redemption structure which incorporates the unrealized gain/loss thus preventing specifically this kind of problem where an investor can over-redeem their account relative to it’s actual NAV-based value). Likely this is the part that will really get Karen because it will be difficult to defend.
All in all, I think that there are some really useful lessons here for those that are trying to replicate this method.
FIRST: The method works. Karen successfully used it from 2008 to 2014. A 6 year streak is NOT dumb luck especially considering 2008/2009 was still very volatile. Those that traded in 2014 and 2015 and now have also seen the concept work well during that time.
SECOND: Risk management is key. You need to stress your positions on a DAILY basis at the very least. Be aggressive in your model (i.e stress test with bigger drops and more vol jump that you want to). A few more contracts won’t make a huge difference in your return, but they can put you under much more quickly. Know what your position size needs to be and don’t go over it no matter how tempting it is. you might get lucky and the market goes your way, but if it doesn’t you’ll start taking big losses. When Karen said she was at 50% margin in an UN-stressed market, that was a clue that it was too much. If you thoroughly examine her method and trade her way but keep risk limited based on appropriate stress test parameters, at low vol on ToS you will see that she should have been at 20-30% margin no more.
THIRD: It’s not the puts that will kill you! It’s the calls. When market goes up and your call side gets stressed, you have to make up that premium at much lower IV. That means you have to sell a lot more calls OR sell puts at the worst possible time (market up and low IV) which leaves you extremely vulnerable to a drop, just like what happened to Karen in Oct 2014. The lesson here is calls don’t generate that much premium anyway, so sell LESS of them, and be very careful adjusting your position on the call side.
FOURTH: If you are inclined to manage other people’s money, do NOT let that pressure make you deviate from your plan. If you have investors not happy with returns, let them leave! With this strategy, you need to accept that in a bull market you will likely not beat the market and may underperform. It’s tough (especially in a long bull like 2011-2014) but that’s the only way you can stay within acceptable risk to avoid getting killed when the market turns.
So there it is. What happened and the lessons. I think we can all learn a lot here. The good thing is that once again an OTM put seller has gotten bad press. So there will be much less people looking to replicate this and drive down premium on the very options we’re trying to sell.