Market Timing by Hedge Funds

In my previous blogs I mentioned that one of regulatory issues of hedge fund managers is the market timing practices. Actual incidents have happened frequently in UK and US but not in HK.

Last week NASD imposed its largest fine (US$2.25m) against Paul Saunders, a hedge fund manager of James River Capital Corporation (JRCC), for using deceptive practices to market time through variable annuities.

JRCC is general partner and trading manager of the Jazzman Fund, a hedge fund established specifically to engage in market timing. After personally investing in Jazzman, Saunders, through JRCC, created 19 limited partnerships under Jazzman to increase the hedge fund's ability to market time mutual fund sub-accounts of variable annuities. While each Jazzman partnership appeared to be a separate entity, with a different name and tax identification number, the partnerships all had common owners - a fact that Saunders did not disclose to insurance companies that offered the variable annuities.

From Oct 2001 to Sep 2003, Saunders used these Jazzman partnerships to engage in numerous deceptive practices to evade attempts by insurance companies to block or restrict his market timing in sub-accounts of variable annuities. Saunders opened 20 different accounts for the Jazzman partnerships at one broker-dealer and commenced market timing, sometimes simultaneously purchasing contracts and trading in the same annuity through several Jazzman partnerships. After receiving communications from insurance companies restricting further market timing, the Jazzman hedge fund used three deceptive practices to continue market timing:

• Saunders purchased contracts in the same variable annuity for other Jazzman partnerships and continued trading through those contracts;
• Saunders obtained additional contracts in the same variable annuity, but changed the name of the annuitant. All of the annuitants were actually employees of entities Saunders controlled; and
• When certain insurance companies rejected an annuity contract because it was purchased with a large initial investment, Saunders purchased another contract with a much smaller initial investment. When that contract was accepted, Saunders transferred funds from accounts of other related Jazzman partnerships to the accepted contract and then began market timing in the contract's sub-accounts.

These practices enabled Jazzman to execute approximately 1,000 variable annuity transactions, well in excess of insurance company limits for any single entity. Saunders personally made approximately US$750,000 in illicit profits from the deceptive conduct.

Compared with the overseas practitioners, the games played by the HK hedge fund managers are much more "simple and naive", typically misappropriation of client assets - e.g. the CSA Fund case (Mr Charles Lee Schmitt was finally sentenced an imprisonment of 4.5 years).