Aristotle wrote, "Quality is not an act; it is a habit." Applied to investment matters, the message is paramount. Ongoing vigilance regarding financial models is critical to gauging whether the models are working as they should. The failure to catch a financial model's mistakes can cost millions of dollars and create a litany of problems. Some financial services organizations and their investors have learned the hard way that computer-driven models are only as good as the people in charge of creating, reviewing, and modifying them as needed. Given the fact that the proper management of more than $30 trillion in global assets significantly depends on having good financial models in place, it is important to understand what can go awry and how to avoid material losses.
A recent example of losses resulting from a financial model error should serve as a wakeup call. Three AXA Rosenberg entities settled a $242 million enforcement action by the U.S. Securities and Exchange Commission (SEC) related to a computer programming error. According to SEC Director Carlo di Florio, the firm swept the error "under the rug" as opposed to dealing with it immediately by communicating with clients. Doing so cost the firm $217 million to be paid as recompense to investors who were harmed, $25 million in penalties, and the costs of "hiring an independent consultant with expertise in quantitative investment techniques who will review disclosures and enhance the role of compliance personnel." Carlo di Florio, Speech by SEC Staff, Remarks at the IA Watch Annual IA Compliance Best Practices Seminar, Office of Compliance Inspections and Examinations, SEC, March 21, 2011. Bruce Karpati, co-chief of the Asset Management Unit in the SEC's Division of Enforcement, cautioned "quant" managers to be "fully forthcoming about the risks of their model-driven strategies, especially when errors occur and the models don't work as predicted." SEC, Press Release No. 2011-37, "SEC Charges AXA Rosenberg Entities for Concealing Error in Quantitative Investment Model: Firms Agree to Pay More Than $240 Million to Settle SEC Charges."