What Is Portfolio Pumping?
Portfolio pumping, also known as "painting the tape," is the practice of artificially inflating the performance of an investment portfolio. It is typically done by purchasing large amounts of shares in existing positions, shortly before the end of the reporting period.
This practice is especially common among investment funds that hold positions in relatively illiquid securities because the prices of such securities can be more easily manipulated. Securities regulators, such as the Securities and Exchange Commission (SEC), seek to detect and sanction this behavior by monitoring suspicious transactions.
- Portfolio pumping is the practice of artificially inflating portfolio performance.
- It is done by purchasing shares in existing positions shortly before reporting portfolio performance.
- Portfolio pumping helps a fund look more attractive and allows fund managers to generate more fees.
- Public awareness of portfolio pumping has been increased by a series of influential academic articles, and the practice is now more tightly monitored by securities regulators.
- If caught, portfolio pumping leads to penalties and trading license suspensions for the perpetrators.
Understanding Portfolio Pumping
Portfolio pumping is harmful to investors because it provides an inaccurate impression of portfolio performance. This in turn can lead investment managers to collect incentive fees that are not justified by their actual performance.
To illustrate, consider an investment fund that owns shares of XYZ Corporation, purchased at $10 per share. If those shares are valued at $7 shortly prior to the investment fund's reporting period, an unscrupulous manager might inflate their value by placing a large volume of new orders for the stock at an inflated bid price, such as $14 per share.
In the short term, this new demand would boost the fund's stated performance, because the position in XYZ would now be valued at $14 per share rather than $7. In the days following the manipulation, however, the shares would likely revert to their $7 value.
History of Portfolio Pumping
Portfolio pumping began garnering widespread attention following the publication of an article in 2002, entitled "Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds." This article, which was published in The Journal of Finance, provided clear evidence that portfolio pumping is a widespread phenomenon.
Following this research, the SEC and other regulators increased their oversight of portfolio pumping. However, there is reason to believe that the phenomenon continues to this day.
In 2017, a researcher from the University of Texas published a study—entitled "Portfolio Pumping in Mutual Fund Families"—in which he outlined how some fund managers have continued to use portfolio pumping strategies by exploiting legal loopholes in the regulatory regime.
Portfolio pumping amongst U.S. equity mutual funds is shown to be more prevalent in single-managed funds rather than team-managed funds; by 45%.
Today, unethical investment managers can also use high-frequency trading (HTF) technologies to perpetrate portfolio pumping schemes. This practice has been the subject of special scrutiny by the SEC, who can punish transgressions by imposing civil fines and by banning actors from working within the securities industry.
Thankfully, the same advanced technologies that are used to manipulate investors can also be used to detect and deter manipulation. To that end, regulators use a variety of advanced analytics software to monitor suspicious trading patterns by using price and volume data from various markets.
In 2014, the SEC charged the hedge fund Archer Advisors LLC with portfolio pumping and bilking investors, specifically its owner Steven R. Markusen and an employee, Jay C. Cope. The portfolio pumping scheme was carried out on the stock of CyberOptics Corp.; a thinly traded stock.
The stock made up over 75% of Archer's holdings, so Markusen and Cope were aware that any trading they did on the stock would impact its price. They "marked the close" on the last trading day of the month 28 times.
This meant that they placed multiple buy orders on the stock before closing to drive up the closing price, which artificially inflated (pumped up) the value of Archer's current holdings. The holdings were valued at the end of the closing day.
This value was used in the calculation of monthly returns that appeared in the fund's prospectus and reported to investors. The returns were also used to calculate the fund's management fee.
What Are the Penalties for a Portfolio Pumping Scheme?
The penalties for a portfolio scheme are primarily fines issued to the perpetrators. The fines vary in size and correspond to the amount that the perpetrators defrauded investors. Penalties also include the suspension or termination of trading licenses.
Does Portfolio Pumping Manipulate Morningstar Fund Ratings?
Yes, studies show that some mutual funds pump portfolios to improve their Morningstar ratings. These funds inflate their month-end values in conjunction with month-end rating cut-offs by Morningstar. Initially, pumping occurred during quarter- or year-end but due to increased scrutiny, this now happens at random month ends.
What Is a Pump and Dump Scheme?
Pump and dump schemes are perpetrated by individuals that hold a specific stock. These individuals then hype up the stock, through recommendations, false advertising, or other underhanded means with no actual reasoning or truth, to entice others to buy up the stock, thereby increasing its value. Once the value of their shares has gone up, they dump the stock, earning a profit.
Is Marking the Close Illegal?
Marking the close is illegal. The SEC's definition of "marking the close" is "attempting to influence the closing price of a stock by executing purchase or sale orders at or near the close of the market."