For all the debate over passive versus active investing, a recent lawsuit raises a simple, fundamental question: What does it even mean to be a passive fund?
The suit alleges that managers of the Global X S&P Covered Call ETF — a $147 million indexed fund trading under the ticker HSPX — actively traded its portfolio to speculate on stocks and generate commissions.
The fund's prospectus said it tracked the S&P 500 Stock Covered Call Index at the time of the alleged activity, according to a complaint filed last month in New York state court in Manhattan.
So how much leeway do funds have? Most index-based stock ETFs commit in their offering documents to investing at least 80% of their assets in the component securities of their underlying benchmarks, a provision intended to give fund managers time to trade in volatile markets and run the fund in the most efficient way to benefit investors. HSPX sought a 0.95 correlation to its index, where 1 would indicate the two moved in lockstep, according to the suit.
Any "wiggle room still has to be used to invest in securities or other instruments that the manager thinks will help track the index," said attorney Eric Simanek, a partner at Sullivan & Worcester who specializes in financial services and who is not involved in the litigation. "It's not there to be used to generate performance that exceeds the index."
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The allegations
ETFs — of which about 98% are passively managed in the U.S. — have
more than doubled their assets to $4.3 trillion over the last four years as investors seek cheaper products that are less susceptible to the decision-making failures of humans.
But funds that track nontraditional gauges have raised questions about the line between active and passive management. Custom-built indexes do not follow a broad market but instead seek exposure to securities based on factors like financial strength or environmental, social and governance concerns, for example. These measures are constructed to reflect strategies that would typically be actively managed, and that rebalance more frequently.
The lawsuit, filed by Kevin Kelly, formerly the chief investment officer of Recon Capital Partners and now a managing partner at Benchmark Investments, states that he learned about the alleged active management of HSPX as his firm was being bought by South Korea-based Mirae Asset Global Investments — which oversaw HSPX — in 2016.
He said that during deal negotiations, he discovered that HSPX outperformed its underlying index by buying back options before their roll date, writing calls midmonth and writing calls with strike prices outside the index's methodology — among other practices.
"The prospectus was materially false and misleading because HSPX engaged in acts, practices and a course of business which was fraudulent, deceptive, and manipulative," according to the complaint.
Mr. Kelly says he flagged his concerns to Mirae and Horizons — the Mirae unit that ran HSPX — in December 2016. He says he recommended that HSPX's underlying index be changed to tackle some of the alleged behavior, but his complaints and recommendations were dismissed.
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Index change
After leaving Mirae in May 2017 and retaining counsel, Mr. Kelly said he filed a whistle-blower complaint with the Securities and Exchange Commission. The agency declined to comment.
In December 2017, HSPX began following the Cboe S&P 500 2% OTM BuyWrite Index. The Cboe index differs from the previous one in that its written call component is achieved by writing call options on the S&P 500 Index rather than on individual stocks that compose the S&P 500.
HSPX was rebranded with the Global X name in 2018 after Mirae added Global X Management Co. to its stable of issuers.
Global X declined to comment on the lawsuit, and Mirae did not immediately respond to an email seeking comment. Exchange Traded Concepts, which set up HSPX in 2013 under the Horizons brand, also declined to comment.
The allegations against HSPX are part of a broader complaint brought by Mr. Kelly against his former business partners Garrett Paolella, Troy Cates and Ray Bartoszek. Mr. Kelly is seeking monetary damages in an amount to be proven at trial.
"The New York Supreme Court filing is a baseless attempt by a disgruntled former colleague of Mssrs. Paolella, Cates and Bartoszek to extract monies that do not exist," said attorney Elizabeth Acee of Barclay Damon, who represents the trio. "The suit is wholly without merit, and we intend to defend it vigorously and are analyzing other potential legal remedies."
The case is Kelly v. Paolella, Supreme Court of the State of New York, County of New York, 657090/2019.
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