BlueCrest Capital was wildly successful as a hedge fund for many years. Its principals were wealthy enough that they could start a new fund with their own money and dedicate traders to running that new proprietary fund. That’s okay, even if the trading strategies between the new proprietary fund the existing hedge fund overlap. Compliance can manage the overlap. BlueCrest would need to properly disclose the conflict to investors.
The Securities and Exchange Commission said that BlueCrest failed to properly disclose. The parties agreed to a $170 million settlement.
The SEC order finds that BlueCrest made inadequate and misleading disclosures concerning existence of the proprietary fund, the movement of traders from the hedge fund to the proprietary fund, the use of the algorithm in hedge fund, and associated conflicts of interest. According to the order, BlueCrest transferred a majority of its highest-performing traders from the hedge fund to the proprietary fund, and assigned many of its most promising newly hired traders to the proprietary fund.
What caught my attention in the order was that BlueCrest failed to disclose that it reallocated the transferred traders’ capital allocations in the hedge fund to a semi-systematic trading system, which was essentially a replication algorithm that tracked certain trading activity of a subset of BlueCrest’s live traders.
As you might expect, the algorithm underperformed the live traders. Why else would there be a SEC case? If the algorithm was better, the SEC would not have bothered. Actually, I bet BlueCrest would have used the algorithm on the proprietary fund if was outperforming the live traders.
According to the order, the hedge fund algorithm basically made the same trades as the live traders in the proprietary fund, but did so the following day. The algorithm trades ended up being less profitable, resulted in more volatility and had more risk in its portfolio.
There is nothing wrong with this practice as long as it’s disclosed. The SEC order highlights some diligence questionnaires which the SEC found misleading in BlueCrest’s description of its trading strategies and use of algorithms.
The SEC thinks there is a big difference between live traders and algorithms and the use of algorithms needs to be disclosed.
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