By JEFF SOMMER
Published: June 18, 2010
INVESTING is always an act of faith, but perhaps never more so than when you entrust your money to a quant fund.
Quantitative funds, after all, are the “black boxes” of investing — portfolios run by managers who generally try to generate profit with computer algorithms that they don’t share with outsiders, or even their own investors.
When you put your money into one of them, you are trusting not only that the overall strategy is sound, but also that its algorithms make sense and, furthermore, that they have been translated properly into computer code.
But quants are humans. They make mistakes. When errors are embedded in computer code, they may go undetected for weeks, maybe even years. And once an error is discovered, it may take months to fix and even longer to determine its financial impact.
This is precisely the headache faced by people who put their money in portfolios run by AXA Rosenberg, a quant subsidiary of AXA S.A., the French financial services giant.
In a letter on April 15, AXA Rosenberg told its clients — which include mutual funds, pension funds and holders of separately managed accounts — that it had made a “coding error” that affected returns in its various portfolios in ways that had yet to be determined.
The letter didn’t explain the specific nature of the error or when it was made. It said the problem “was first discovered in late June 2009” but that the company did not correct it until somewhere “between September and mid-November.” AXA Rosenberg did not notify clients until the mid-April letter.
Some clients decided they had had enough. On April 21, for example, the of Ohio terminated AXA Rosenberg’s management of a $25 million small-capitalization stock portfolio.
“It wasn’t so much the coding error itself,” but that it took so long “to inform us of the error,” said Tim Barbour, a spokesman for the pension fund. “It is a fundamental question of trust.”
And Charles Schwab is closing four mutual funds run by AXA Rosenberg. “AXA Rosenberg lost the confidence of the funds’ board,” said Greg Gable, a Schwab spokesman.
AXA Rosenberg, based in Orinda, Calif., had $41 billion in assets under management on May 31 — down from more than $62 billion in March, according to its Web site.
It has provided few details about the problem. Axa Rosenberg’s executives declined to comment. “The reviews of the facts and circumstances surrounding the coding error and its impact are well under way but not yet complete,” the company said in a statement. Another firm, Cornerstone Research, is to report on the effect on individual portfolios next month, AXA Rosenberg said in a June 9 letter.
Kevin Callahan, a spokesman for the Securities and Exchange Commission, said the agency would not confirm or deny whether it was conducting an investigation into AXA Rosenberg.
Some clients have been told more about the coding error. It was an “inadvertent mistake” entered into one of AXA Rosenberg’s main “risk models” by a computer programmer in April 2007, according to information provided to the Vanguard Group.
The effect on three Vanguard mutual fund portfolios run by AXA Rosenberg isn’t clear, but the glitch appears to have been “mitigated” by other software, according to Daniel Newhall, head of manager oversight and selection in Vanguard’s portfolio and review group. He said that on May 31, AXA Rosenberg handled $1.1 billion of Vanguard’s $8.9 billion Explorer fund, $334 million of the $489 million U.S. Value fund and $31 million of the $66 million Market Neutral fund.
“We are concerned, of course,” he said. “A quantitatively managed strategy does depend on correct coding.”
Vanguard is awaiting Cornerstone Research’s report. Mr. Newhall said he was pleased by management changes announced by AXA Rosenberg in a second June 9 letter. Barr Rosenberg, who founded the company, is stepping down as chairman and head of research, and the corporate parent is taking more direct control of its quant subsidiary. The research center, which had functioned quasi-independently, is to report more directly to corporate executives.
Still, investors have been leaving. Schwab is shutting down the Laudus Rosenberg funds, four quant mutual funds whose portfolios have been run by AXA Rosenberg. They are the Laudus Rosenberg U.S. Large Capitalization fund, with $100.9 million in assets on March 31, according to Schwab; the U.S. Discovery fund, with $347 million; the International Discovery fund, $341.6 million; and the International Small Capitalization fund, $340.8 million.
The performance of the funds has been disappointing, said Mr. Gable at Schwab, though it is not clear how much of that is attributable to the glitch. U.S. Discovery, for example, lost 41.2 percent in 2008, versus a loss of 37.3 percent for its benchmark, the Russell 2500 stock index, according to Bloomberg. In 2009, the fund gained 27.2 percent, versus 34.3 percent for the index. This year through Thursday, it gained 7.7 percent, versus 7.2 percent for the index.
Several pension funds have ended AXA Rosenberg’s services. In addition to the Ohio school retirement system, for example, the Florida Retirement System Pension Plan decided on April 20 to end AXA Rosenberg’s management of a $400 million United States large-cap fund, said Dennis MacKee, a spokesman for the plan. “We just concluded that AXA Rosenberg’s control process was inadequate,” he said.
ONE question is whether AXA Rosenberg itself — or the various mutual fund groups, financial advisers and consultants that have used its services — monitored its operations with sufficient rigor.
In a blog post, Michael Markov, C.E.O. of Markov Processes International, a quantitative research firm, said calculations using daily prices of AXA Rosenberg’s mutual fund portfolios suggest that by early 2009, there was “an apparent aberration” in the funds.
Mr. Markov said he had examined the funds’ tracking error and beta, a common measure of sensitivity to a benchmark’s movement, to show that the funds’ performance deviated in an unusual way. This could have been picked up much earlier, he said in an interview. (He said that in 2008, the problem might have been masked by the bear market.)
Still, Mr. Markov said, AXA Rosenberg should receive credit for acknowledging the error.
“Errors are made by quant funds all the time,” he said, “but they aren’t always revealed.” Investors need to be more vigilant, he said, and use more sophisticated monitoring tools. “Trust,” Mr. Markov said, “but verify.”
From The New York Times published on June 18, 2010
