Cherry-Picking Allocations – Article ( Articles )
Cherry-Picking Allocations (CPA)
A Risky Game in Investment Management
In the world of investment management, CPA refers to a practice where portfolio managers selectively allocate investments to specific funds or strategies based on their recent performance, often favoring those with strong recent returns. While this approach may seem appealing, it carries significant risks and can lead to suboptimal portfolio performance over the long term.
“Cherry-picking” is a fraudulent securities trading practice in which the responsible individual executes trades without assigning those trades to a particular trading account until the individual determines whether or not the trade has become profitable or suffered losses. The responsible individual then allocates the profitable trades to favored accounts – often the individual’s own accounts – and assigns unprofitable trades to disfavored client accounts.
Source: U.S. Department of Justice
The Allure of CPA
The temptation to cherry-pick stems from the human tendency to chase past performance. When a fund or strategy has delivered impressive returns, it’s easy to believe that this success will continue. This approach often leads to:
- Investing in “hot” funds: Managers may allocate funds to strategies that have recently outperformed, ignoring factors like underlying risk, fees, and the sustainability of past performance.
- Ignoring underperforming assets: Funds or strategies that have underperformed in the recent past may be overlooked, even if they offer long-term value or diversification benefits.
The Pitfalls of CPA
- Performance Chasing: Past performance is not a guarantee of future results. Funds that have performed well in the past may be due for a correction, and chasing past performance can lead to significant losses.
- Lack of Diversification: Focusing on a few “hot” funds can lead to concentrated portfolios with limited diversification. This exposes investors to greater risk, as a downturn in one fund can have a significant impact on the overall portfolio.
- High Fees: High-performing funds often come with higher fees. Cherry-picking can lead to higher overall portfolio costs, eroding returns over time.
- Missing Out on Long-Term Value: Cherry-picking can lead to missing out on long-term value by ignoring underperforming assets that may offer potential for growth in the future.
Regulatory Scrutiny
The practice of CPA has not gone unnoticed by regulators. Increased scrutiny has emerged due to concerns about the potential for misleading practices and the impact on investor outcomes. Key points of regulatory focus include:
- Transparency Requirements: Regulators emphasize the need for investment managers to provide clear and comprehensive disclosures about their investment strategies and performance metrics. This helps ensure that investors are not misled by short-term performance.
- Fiduciary Duty: Investment managers are often held to a fiduciary standard, requiring them to act in the best interests of their clients. Cherry-picking can conflict with this duty if it leads to suboptimal investment decisions.
- Enforcement Actions: Regulatory bodies, such as the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), have taken enforcement actions against firms that engage in misleading practices related to performance reporting and allocation strategies.
A More Prudent Approach
Instead of CPA, a more prudent approach involves:
- Long-Term Perspective: Focus on investing in funds and strategies with a proven track record of consistent performance and a clear investment philosophy.
- Diversification: Allocate investments across a range of asset classes and strategies to mitigate risk and enhance portfolio resilience.
- Cost-Consciousness: Consider fees and expenses when selecting investments, as these can significantly impact returns over time.
- Regular Review and Rebalancing: Periodically review and rebalance the portfolio to ensure that allocations remain aligned with investment goals and risk tolerance.
Conclusion
CPA may seem appealing in the short term, but it is a risky strategy that can lead to suboptimal portfolio performance over the long run. With increasing regulatory scrutiny, investment managers must be vigilant in adhering to best practices and maintaining transparency. By adopting a more disciplined and long-term approach, investors can increase their chances of achieving their financial goals.
Agency Resources:
- (USDOJ) (www.justice.gov) – “Connecticut Investment Advisor Imprisoned for Defrauding Clients of $2.7 Million Through Cherry-Picking Scheme”