Back in December 2016 the Securities and Exchange Commission (“SEC”) brought a case against PIMCO whereby PIMCO used odd lot securities in a newly launched fixed income fund. At the time, PIMCO agreed to be censured and consented to the SEC’s order without admitting or denying the findings that the firm violated Sections 206(2) and 206(4) of the Investment Advisers Act of 1940, Rules 206(4)-7 and 206(4)-8, and Section 34(b) of the Investment Company Act of 1940.  PIMCO agreed to pay disgorgement of fees totaling $1,331,628.74 plus interest of $198,179.04 and a penalty of $18.3 million.

We remind portfolio managers that the SEC still looks for such situations today. Odd lot fixed income securities, are frequently priced at a discount to similar round lot bonds. While this gives an advantage to niche and nimble money managers to exploit these market inefficiencies for their customers, it has other consequences as well; When assets grows large enough, the manager may not be able to achieve the previously obtained performance, as it can no longer rely on odd lot purchases to satisfy the Fund’s growth in size.

Independent valuation service providers may use round lot bonds to value the securities. This has the potential effect of showing a small but immediate unrealized profit on the odd lots held in the portfolio. In reality, if the fund needed to sell the odd lots they may only be able to obtain a discount to the round lot price used by the pricing services.

These situations have compliance consequences.

Marketing and performance material used for a Fund may be considered misleading as spelled out in the Clover Letter. Managers may not show performance without disclosing the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser's clients appreciated in value by 25% without disclosing that the market generally appreciated 40% during the same period. In the PIMCO case, according to the SEC, “The initial performance was attributable to buying smaller-sized bonds known as “odd lots” as part of a strategy to help bolster performance out of the gate.  But in monthly and annual reports to investors, PIMCO provided other, misleading reasons for the ETF’s early success and failed to disclose that the resulting performance from the odd lot strategy was not sustainable as the fund grew in size.”)

Using a third party valuation service provider when you know or should have known the service provider’s valuation does not accurately reflect the portfolio’s valuation. In PIMCO’s case as stated by former SEC Enforcement Director Ceresney, “PIMCO overstated its NAV almost every day for four months because its policies and procedures were not reasonably designed to properly address issues concerning odd lot pricing,”

Compliance actions.

Take care when marketing performance when the performance may not be sustainable and ensure that you provide appropriate disclosures as necessary. Conduct your ongoing due diligence for pricing services as well as all material service providers. When using less transparent securities as part of your investment strategy, include a review of the pricing service’s process or compare the valuations to your best execution review to ensure pricing is accurate. When prices are awry, take action which may include; Challenging the pricing service, or adjusting the portfolio pricing.

If you have any questions regarding the topics discussed herein, please contact your NCS Consultant.