What Is Cherry Picking?
At its core, cherry picking occurs when a broker abuses their power to allocate trades. The broker selectively allocates profitable trades to their own account or to preferred clients, while losing trades are pushed onto other clients. This can happen when trades are executed in bulk, through omnibus accounts, and not allocated immediately. Brokers are expected to follow a fair, impartial and predetermined allocation process, but that doesn’t always happen.
When Allocation Isn’t Fair: A Case of Skewed Trades
A recent case from the U.S. Securities and Exchanges Commission (SEC) that closed last month has all the classic hallmarks.
In this case, the perpetrator was an investment advisor handling about $52 million in trades during the investigation period. Most traders were executed through block-trades and then subsequently allocated out. The advisor would wait at least a day to see which trades performed well or badly. Well performing trades were then assigned to accounts owned by himself, his wife and other family members, while underperforming trades were allocated to his clients.The SEC’s evidence pointed out that the favored allocations had a 75%-dollar weighted win rate, compared to the other accounts that had a 47%-dollar weighted win rate. Over the period, the favored accounts achieved an average return of 4.7%, while the other accounts only saw 0.1%. Statistically, the SEC noted, the likelihood of this happening naturally was less than 1%.
The Motivations Behind Cherry Picking: Beyond Profit
It’s important to understand that the motivations for cherry picking aren’t always driven by direct monetary gain. Sometimes it’s about client retention, where more profitable trades are allocated to favored clients who pay better fees or are able to refer new clients. Other times, it’s about artificially boosting the reported performance of a specific fund to attract new investors or hit performance benchmarks.
Trading for Recognition: The FCA Case That Changed the Rules
A notable example of the latter is a case from the U.K. Financial Conduct Authority (FCA), which has since influenced global best practices.
In this case, the perpetrator managed two funds side-by-side: an active hedge fund with high performance fees and a more conservative, low-fee “long-only” fund. He delayed allocations to identify the best-performing trades, allocating them to the hedge fund and the poor performers into the low-fee fund. A clear conflict of interest.
What’s particularly interesting is his motivation. According to the FCA’s detailed notice, he wanted to “gain recognition for his trading ability from his colleagues.” It goes on to say that “he had not been promoted despite being at Aviva Investors for a number of years and felt demoralised, stressed and under pressure to prove his trading ability in order to be promoted.”
Also notable: he delayed allocations by hours rather than days, so everything was happening at an intra-day level. Yet even within this short window he persistently misreported trades, with 56% of trades being misreported by over an hour.
Guarding Against Cherry Picking: Policies, Audits, and Performance Analytics
So, how can firms guard against cherry picking?
- Clear or Automated Allocation Policies: Firms should document and consistently apply transparency allocation criteria that is applied consistently to all clients.
- Regular Audits: Compliance officers of external auditors should routinely review trade allocations to detect anomalies, including an analysis of the timeliness of the allocation.
- Statistical Analysis: Comparing account performance managed by the same broker and keeping an eye out for unlikely high performance.
Why Cherry Picking Undermines Market Integrity
Though a fairly simple scheme, cherry picking wears down trust in the investment industry since it’s fundamentally unfair and non-transparent. If investors lose faith in those managing their savings, the entire financial ecosystem is called into question.
