A U.S. mutual fund that suffered nearly $500 million of losses appears to have misvalued its large derivatives portfolio, according to an analysis of the fund’s disclosures by The Wall Street Journal, academics and traders.
The Infinity Q Diversified Alpha Fund disclosed in filings with the Securities and Exchange Commission valuations of investments that in at least three instances were incorrect or inconsistent with market conditions, said traders and academics. One valuation was mathematically impossible, said a former Morgan Stanley managing director who reviewed the disclosures.
In one instance, the disclosures show, Infinity entered two nearly identical swaps contracts referencing the same index over the same period, yet booked a gain on one that was more than three times as large as the other—an outcome analysts said defied logic. Swaps are bilateral contracts, brokered by banks, that traders use to bet on asset prices, interest rates or other financial trends.
In February, the firm made the unusual move of halting redemptions to investors and saying it could no longer value its holdings. At least two people raised concerns about the fund to the SEC, and it is under investigation by the regulator, people familiar with the matter said.
The SEC informed Infinity of evidence that the firm’s chief investment officer, James Velissaris, was adjusting parameters of third-party pricing models used to value its derivatives, leaving Infinity unable to accurately value its holdings, the firm has said.
Infinity also has said it barred Mr. Velissaris from trading, placed him on administrative leave and is reassessing previous valuations before it returns money to investors.
The Federal Bureau of Investigation and prosecutors at the Manhattan U.S. attorney’s office are also investigating, the people familiar with the matter said.
A spokesman for Infinity and Wildcat Capital Management, a family office affiliated with the firm, said they were “both working cooperatively with the SEC and all other government agencies and are supportive of the steps now being taken to maximize returns to investors.”
Mr. Velissaris declined to be interviewed through his spokesman. Sean Hecker, Mr. Velissaris’s lawyer, said two of the misvaluations described by the Journal were “clerical errors” that had been remedied and that Mr. Velissaris made efforts “to act in the best interests of investors.”
The Journal interviewed half a dozen equity derivatives traders and academics who reviewed Infinity’s positions as published in regular disclosures with the SEC. Those interviews and the Journal’s analysis of the fund’s portfolio revealed departures from standard practices in how some investments are typically valued.
The mutual fund, which launched in 2014 and is a part of Infinity Q Capital Management LLC, sought to generate returns that weren’t as tied to the returns of other assets like stocks and bonds, its disclosures showed. One investor at a family office said the firm considered the mutual fund a hedge to its holdings.
It appeared to pay off, particularly during the brunt of last year’s selloff. In March 2020, the mutual fund posted a return of about 7%, while the S&P 500 fell 12.4%, its worst month since 2008. That month, the fund drew its highest inflows ever, according to Morningstar Direct data.
Infinity attracted more than $1 billion of inflows last year and has boasted of its affiliation with Wildcat, which is the family office of David Bonderman, the founding partner of private-equity giant TPG. A now-archived version of Infinity’s website states that Infinity Q Capital Management was “managed by David Bonderman’s family office.”
A spokesman for Wildcat—who also represents Infinity Q—said the firm “was shocked and disappointed to learn of the SEC’s allegations” tied to Mr. Velissaris, and that Infinity Q “has been majority owned and controlled by Mr. Velissaris. Bonderman family investment vehicles have only been passive investors in Infinity Q Capital Management.”
Mr. Bonderman declined to comment through a spokesman.
Infinity took positions in stocks, currencies and other assets across markets, but analysts trying to figure out what went wrong have focused on its use of complex Wall Street products, including those known as variance swaps. They enable investors to bet that price moves in indexes like the S&P 500 will exceed or fall short of a fixed amount over a stated period. Swaps can be tailored by the users, such as investors and the banks they trade with, to make a pure bet on a specific outcome.
The nature of swaps and Infinity’s disclosures with the SEC make it possible to determine how some of the investments were being valued, traders and academics said, and whether those valuations were appropriate. In some cases, they said, it appears they weren’t.
Take the case of a swap that Infinity Q sold tied to the MSCI World Index, according to its disclosures in February 2020. Investors often sell swaps as a way of betting that volatility will decline.
Traders and analysts evaluated the size of the position—which stood to gain about $600,000 for a small drop in volatility—and what’s known as the strike, or the level of volatility the bet is tied to. In this case, that number was 17.3%, Infinity’s disclosures show.
On Feb. 29, 2020, Infinity’s filing showed a gain on the position of $5.6 million.
But given the stated terms, the most Infinity could expect to make on the trade would be $5.2 million, according to Peter Carr, a former Morgan Stanley managing director and chair of the Finance and Risk Engineering Department at the New York University Tandon School of Engineering. That would be the gain if volatility fell to zero.
Such a drop would be rare—volatility hasn’t fallen to zero in the S&P 500 since its inception in 1957.
“There is no justification for that gain,” said Mr. Carr, who has helped write formulas to value variance swaps and followed them for more than two decades. He reviewed the position and said the gain was mathematically impossible.
A few months later, in May 2020, Infinity Q disclosed holding two nearly identical swaps tied to the Russell 2000 index. As the buyer, Infinity Q was betting that volatility in the Russell index would exceed 22.4% in one case and 22.8% in another, over the identical term of 12 months.
The swap that had the lower hurdle of 22.4% was somewhat more aggressive, putting about $250,000 at risk for a small change in volatility, compared with roughly $150,000 at risk for the swap with the higher hurdle. Infinity’s gains stood to rise exponentially as volatility jumped above those thresholds.
Yet the gains the fund booked on the first trade were more than three times as large as on the second, a divergence that academics said was too big to be accounted for by position size or other stated variables. One showed a roughly $13 million gain and the other a $4.1 million gain.
“Both of those gains can’t be right,” said Mr. Carr. He said at least one of the inputs used was wrong—Infinity should have used the same input for expected volatility in the Russell for both swaps. That means the valuation on at least one of the swaps was incorrect, he said.
Mr. Hecker said “both of the examples that were provided to us involve clerical errors that have been previously identified, remedied and reported.”
There are other oddities in the firm’s disclosures. Paul Staneski, founder of consulting firm Derivatives Solutions, says the firm’s variance swap portfolio appeared overvalued by tens of millions of dollars as of May 2020.
The prices the fund used “were unusually favorable and not consistent with where the market was,” Mr. Staneski said. “They’re so far off, they’re not in the ballpark with [volatility] that anybody is reporting.”
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To be sure, expectations of volatility can differ among various banks providing quotes to clients and data vendors, Mr. Staneski said. But for some swaps, expected volatility at the time would have had to be outside the range of normal expectations, he said.
In another instance last May, Infinity disclosed that it had sold a variance swap tied to the S&P 500, a bet that would profit if volatility declined through the end of the year. Instead, volatility skyrocketed as the Covid-19 pandemic spread through the U.S. and hammered markets.
Infinity disclosed around a $5 million loss as of the end of May. But volatility had jumped so much—the Cboe Volatility Index rose to as high as 37 that month from around 16 in early February, when the swap became effective—that Infinity was likely sitting on a loss of roughly three times that, Mr. Staneski and other traders said. Shortly after the swap went into effect on Feb. 4, the S&P 500’s 11-year-old bull market abruptly ended.
Mr. Hecker said that “Bloomberg’s interactive pricing tool is designed to be used interactively by users to make reasonable estimates of asset valuations, and any inquiry will determine James used these tools and others when determining appropriate valuations as part of his efforts to act in the best interests of investors.”
Investors say they are expecting big losses. Infinity recently valued its holdings at around $1.2 billion, or roughly 28% below the $1.7 billion disclosed on Feb. 18, the last day it calculated a net asset value.
The firm said in an update to investors that the plunging value of its holdings stemmed primarily from over-the-counter trades—including variance swaps and other swaps and options trades—that it had with a range of banks. Complex positions like swaps made up almost a fifth of the firm’s value in February, before it started liquidating, the firm said.
Mr. Hecker said the latest valuation “reflects distressed liquidation values that were adversely affected by the fund being in default during the liquidation process.”
It isn’t known how much investors might ultimately recoup after legal fees. An investor in the fund has filed a lawsuit seeking class-action status against the firm, alleging that it made misleading statements about its business and financial results, and that executives intended to deceive investors. Infinity’s spokesman declined to comment on pending litigation.
Infinity is expected to present a plan to distribute funds to investors by May 24.
—Rebecca Davis O’Brien contributed to this article.
Return on a Variance Swap
An investor’s return on a variance swap is determined by the actual level of volatility in markets, compared with the level she had initially projected.
Calculating the valuation involves a formula with several inputs that can be found in Infinity’s SEC disclosures.
They include what is known as the strike, or the level of volatility bet on; the size of the position, known as vega; and realized variance, or the actual swings in stocks.
Because selling a swap is profitable when volatility falls, an investor would receive the maximum hypothetical return if volatility in that stock dropped to zero. Although that would be highly unusual, making that assumption sheds light on the maximum possible gain on the position.
Here’s the math.
- What we know about Infinity’s short swap position from its Feb. 29, 2020, disclosure: Vega notional (position size)= -$600,000 [the negative sign indicates that they are selling the swap]. Strike=17.3%. Underlying Stocks: Invesco MSCI World UCITS ETF.
- This is the formula used to value the swap: Valuation= (Vega notional/ (2x strike))(strike²-realized variance²).
- To calculate the most money one can make selling the swap, plug in “zero” for that realized variance figure. Valuation= (600,000/(2×17.3)) (17.3²-0²).
- Valuation=$5.2 million. Infinity’s Disclosed Valuation= $5.6 million.
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