Is this transaction a cash flow?
If it's a cash flow your performance suffers, but is that fair, because you sold the stock before you would have.
Regardless, I would say that you are essentially reversing the trade, which means you're restoring the account to the condition it was in before the trade was done (essentially acting as if the trade never occurred). I think that the funds are not to be treated as a cash flow. While you cannot alter the official books and records, your records should portray this as a "non event."
What do you think? Chime in, by commenting below.
p.s., Several years ago I advised a client to purchase a trade order management system; they held off on this roughly $100,000 purchase. A few months later they had a trade error that cost them more than $500,000.
p.p.s., We have received a few comments (see below) that you should read. Steve Campisi suggests that this may "bend the law." Derek points out that many firms move these trades into their error account. And Jed raises the question about the other side: if the stock's price goes up!
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Interesting topic and I definitely agree with the way you suggest to handle it. The trade should never have been made to begin with and the client becomes whole so why penalize the manager with a loss of basis points.
ReplyDeleteHowever....
What if the sale of the tobacco stocks produced a gain instead of a loss? The manager probably isn't going to ask for the money back from the client AND will probably accept the extra basis points from the gain.
I guess that's okay from a client's perspective, but it would inflate a return that shouldn't have been from a manager's perspective.
I heartily disagree. And I think that your suggestion bends the law. You can't contribute capital to create performance, and that's what you would do with your suggestion. Perhaps that's an example of why it's said that "The road to Hell is paved with good intentions."
ReplyDeleteMy understanding is that you must compensate the client for your error, making them whole using your money. And, the account's performance suffers, as it should due to your error. So, the result is (and should be) doubly painful for you, the creator of the error: a) you lose performance as you recognize the trade correction and b) you lose your money, giving you less personal wealth.
Good. Next time, hopefully you'll know better. There should be a zero tolerance for trade errors. This policy helps to reinforce more careful behavior.
Jed, thanks for your comment. Interesting point to consider. However, Steve, too, has chimed in, and his points are also of value.
ReplyDeleteAs for it bending the law, I am unsure about this. I do not know what law would be bent. The compensation you agree with; it appears you only disagree with it not being treated as a cash flow for performance purposes.
This topic came up recently and the folks seemed to agree that this idea had merit. It would be interesting to find out how firms are actually doing this and if any laws are being bent or broken.
Don't firms usually have a separate account set up (we always called it the "error account")? When you notify the broker of the error they typically reallocate the order from the client's account to the manager's account. That way if it's a loss of a gain, it doesn't matter to the client or the composite.
ReplyDeleteDerek, I believe that in many cases this IS what is done; the trade is just rebooked to their account. But apparently this isn't always the case, thus the reason behind this post.
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