How meme-stocks wrecked your Fund Manager
Or: "If they're good at investing, why not just keep going...?"
Hedge funds are failing
Since late 2021, several investment funds and high-profile professional portfolio managers have suffered heavy losses after throwing their clients’ money into unproven nano/microcaps, meme stocks and/or other speculative, volatile gambles, companies that were wildly unprofitable but massively hyped. For brief moments they looked like investing gods, but many have since quickly closed up shop here in the Nordics and beyond. Some of these failures have been very public, widely reported and subsequently debated in news and investment forums, where peoples’ reactions often express confusion, disappointment and occasionally, schadenfreude. Evidently, people love to love you when you’re winning, but love to hate you more when you lose.
A commonly recurring question I see in investor forums is “But these managers are/were good, why quit now? Why not continue, get all the (customer) money back, and keep earning (presumably juicy) fees?”.
The dramatic TL;DR is:
Even a talented fund manager might be practically forced to quit after even a short period of *severe* poor performance, because their alternative is to probably starve for *years*.
Don’t believe it? Let me explain:
First, we need to understand the main fees that Funds charge Investors, typically some combination of an Assets Under Management Fee and Performance Fee. A (highly simplified but hopefully clear) description follows..
Imagine that a skilled fund manager can achieve, over the long term, 15% Compound Annual Growth (CAGR), and you will invest with them. (Despite what crypto-enthusiasts would have you believe, growing your investments at 15% per year over the long term is quite extraordinary, and 20% CAGR is the stuff legends are made of. Keep mental note of this fact, it will be important later)
An investment of $100 000 growing at 15% with no fees or costs, would double in 5 years (waves hands, Excel appears… you can download and try these out at home)
Enter the Assets Under Management (AUM) Fee
In an investment fund, the AUM fees are kind of like the cost-of-entry, pay-to-play fee. It’s the fee that a fund charges to investors simply for the privilege of holding your money and trying to do smart things with it, and is often explained/excused/dismissed as “fees charged to help cover the basic operating costs of the fund”. If you, the investor, want to invest $100 000 and the AUM fee is 2% then WHAMMO… you’re $100 000 x 0.02 = $2 000 poorer, just for stepping in the door. And each year after, another 2%, even if your investments don't grow at all!
Note the effect just the AUM fee has on your ultimate outcome - your manager takes the AUM fee each year BEFORE they invest your money, so there is less initial cash to grow over each year. After 5 years, you have $181 811, or approx $19 000 less than in the original zero-fees example.
The Performance (Perf) Fee
The Performance Fee is where things get even more interesting, the idea being that when investors win, the fund manager also wins. The Perf Fee is the incentive, the reward that a fund earns for turning your money into more money. If your $100 000 investment grows by 15% in Year 1 with a 20% Performance Fee, the fund will charge $100 000 x 0.15 x 0.20 = $3 000 and your account shows $112 000, and so on.
And of course, if the fund charges both AUM and Perf fees, you’re that much poorer while your manager gets that little bit richer - first they take their AUM Fee… then your less money grows less… then they take their Perf Fee. Your $100 000 turns into $165 000 over 5 years, or $35 000 (and indeed, 35%) less than the zero-fee base case.
Where did that $35 000 go? Well, see the the outcome to your fund manager, if they take their AUM and Perf Fees and invest them the same way for the same 15% CAGR:
Ah-hah. There it is1.
Mind you, if the manager IS good, AND their strategy is effective and better than you could do yourself at lower cost, and not overly high-risk, AND their fees aren’t ridiculous, then you get richer and they probably deserve to get paid. Historically, 2-and-20 was a typical hedge fund industry fee structure but is now seen as high. More commonly now you might see 1-and-15/18. Some funds will go AUM-only, some 0-and-25… it varies, but you get the idea. Think looooooong and hard about the fees you’re paying, and the effect they will have on YOUR end result. The more you pay in fees, the less you can spend on beer and skittles in your retirement.
Hopefully I’ve shown that that managing Other People’s Money (OPM) can be a lucrative business for a fund manager, when things are going well. So why are all these funds closing down after suffering recent investment losses in 2021/22? can’t they just return to business as usual?
I present to you the2 twin curses to the fund manager: The Hurdle Rate and High Water Mark.
The Hurdle Rate(HR)
Simply put, a hurdle rate is the *minimum* percentage that your fund manager has to achieve when they manage your money, *before* they can charge you performance fees. For example, lets say you invest $10 000 000 in a stock market fund with a 3% hurdle rate. In year 1 your investments grow by 2.9%.
Congratulations — you will pay no fees to your fund manager for that time period, because if my math skills are correct, 2.9% < 3%. (But also, UnCongratulations — there’s a chance your fund manager isn’t very good3).
So in the event of a year where investment returns are lousy-but-not-awful, the fund manager will collect their AUM fee to pay running costs, and have to survive a year without their usual Perf bonus, but presumably, hopefully, they’ve adequately prepared for the occasional bumpy year.
The High Water Mark (HWM)
More critically than the HR however, the High Water Mark also affects Performance fees and the loss of that income is what likely put your fund manager into an unwanted, forced early retirement.
A HWM basically means that if your fund manager grows your investments to $ X and then LOSES money, they CANNOT charge you Performance Fees again UNTIL your balance goes back above $ X. This way, you don’t get penalized over and over if your investment portfolio value bounces up and down, with the manager collecting fees while your account goes nowhere. Instead, the fund value has to recover to its previous high (water mark) before those juicy Perf fees start accruing again.
Enter the Corona-boom and Meme-Stocks
What we saw during late 2020 and H1 2021 was an explosion in the prices of many stocks, and many fund managers who dabbled in small, illiquid or meme-style stocks suddenly looked like investment geniuses, doubling or tripling their clients’ money in a year, and collecting fees, but also setting themselves a HIGH high water mark! See below for a fund launched in 2017, doing “okay” until 2020 and then going, frankly, bananas…
This fund, and many others like it, experienced a once-in-a-lifetime fee harvest, largely by investing in smaller, illiquid and meme-y companies. Which was great for the fund manager while it lasted. When the monkeys came home to roost, so to speak, and prices of those speculative investments slumped, these funds crashed back under their HWM and lost a tonne of investor money along the way:
Let’s return to my original hyperbolic statement:
Even a talented fund manager might be practically forced to quit after even a short period of *severe* poor performance, because their alternative is to probably starve for *years*.
Let’s see the how the boom in 2021, corresponding HWM, and then subsequent crash in market value will affect this and similar funds’ ability to resume collecting (Perf) fees. If our manager historically was able to achieve 15% returns annually, then doubled investor money in a great 2021, then followed that up with an awful 2022 decline of 40%, then, assuming their confidence remains and they had true skill in the first place, they return to making 15% annually.
How many years until they reach the HWM again and can resume collecting performance fees? Returning to our friend Excel, would you have guessed 5+? Five long years of having to outperform the typical investment professional, while pacifying existing upset customers, while *hopefully* covering fund operating costs from the AUM fee and spending down the profits they made (and hopefully saved) in the boom times. Note, I had to extend the table by almost double just to show when the fund would return to profitability!
Fund Management: A great business to be in in the good times, not so great after a particularly rainy day.
So, what’s the take-away?
I am certainly *not* a defender of funds charging high fees or ripping off their clients (looking at YOU, Australian retirement service providers), and my heart won’t bleed for any of the investment teams that wrote loud, congratulatory letters patting themselves on the backs while punting their investor money on Carnava and GameStop, or quirky nano-cap companies based in some remote corner of Iceland etc.
But if you were affected by any recent fund closures and wonder why the fund managers “don’t just keep going and make it all back again”, perhaps this will help clarify — even if they might want to, they likely, practically, can’t.
And more than that, I’m hoping this letter gives you reason to pause and think. If your current fund manager is telling you about how they’re full-throttle in on Nvidia stock at Price/Sales ratios of 40 and their Year To Date profit graph goes from gently-up-and-to-the-right to a full vertical like the example above, ask yourself, how might they handle the (inevitable) bad times? Are they ready? Are you?
Calculations, and sample excel of fund manager fees originally inspired by Terry Smith’s famous “2-n-20 fees are unsustainable” thesis, described (and debated) here
Again, simplified for clarity
At least, if they keep performing at this level over time, you should probably take your money elsewhere, like a low-cost SP500 index fund!