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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former banker and author of ‘Traders, Guns & Money’, ‘Extreme Money’ and ‘Banquet of Consequences’
All investors are equal, but some, especially wealthy and large ones, are more equal. This derives, in part, from the pooling structures — mutual funds, units trusts limited partnerships or equivalents — through which investments are held.
These structures facilitate access to specific assets, investor participation, scale economies and professional management. There is an economic trade-off between returns and additional expenses. But pooling creates several risks.
First, the interests of investors and asset managers are difficult to align. Management fees are on assets under management, driving a focus on attracting inflows rather than returns or risk.
Performance fees create asymmetric pay-offs for the manager. Assume a $100mn fund where the manager has a $5mn interest in the fund (the “skin in the game”) and fees are 1 per cent of AUM and 20 per cent in performance fees — a share of investment returns, usually above a benchmark. If the hedge fund loses $20mn the manager loses $1mn offset by the management fee received. If the fund makes $20mn then the manager earns $4mn plus the management fee ($1mn) — a 100 per cent return.
Conflicts influence shifts in risk profile. Where a fund performs well, the asset manager may reduce the risk to lock-in returns, especially approaching reporting dates. Managers of poorly performing funds can increase risk when facing withdrawal of investor funds.
Attempts to align interests have perverse results. Strict mandates around narrow objectives can discourage staying uninvested when opportunities are unavailable or expensive but also make liquidation to reduce risk difficult (due to the specification of the composition of assets). Performance benchmarks lead to “closet indexing” or “herding behaviour”, averaging out returns.
Second, pooled investments typically value fund investments periodically. There are well-documented difficulties due to liquidity concerns in traded assets and, of course, in untraded private assets. Valuation errors transfer real value between selling and buying investors and misstate wealth and collateral values. In relation to the latter, an unexpectedly large negative adjustment can trigger a cash call where the position is financed with debt.
Fees are affected by valuations. Well over half of all changes in AUM are from performance, mainly mark-to-market changes, not new inflows.
Third, problems of mismatches of assets (underlying investments) and liabilities (redemptions) are known. However, pooled structures that commingle investor funds, create exposure to “weak hands”. Investors who have no need for liquidity and have the capacity to withstand short-term downturns are exposed to co-investors needing to redeem. This may force funds to sell holdings, usually the better, more liquid assets, to raise cash affecting fund returns and risk. Fixed-term funds or lock-in periods lead to bunching of redemptions, exacerbating exit risk.
Fourth, pooled funds come with embedded cash or liquidity risk. Many private market funds are structured with cash calls, contractual commitments to contribute when required. This creates cash flow risks for investors. Fund distributions are also frequently unpredictable, resulting in uncertain flows and tax consequences.
While smaller investors have no choice, high net worth individuals and family offices increasingly favour managed accounts or exclusive dedicated structures where their funds are not co-mingled with other investors to minimise these risks.
Regulatory proposals to tighten rules on liquidity reserves and pricing can address some concerns. Other initiatives could include eliminating fees on AUM resulting from unrealised asset price rises, forcing distribution of income unless investors specifically choose to reinvest and more flexible rules around redemptions or penalties. Ultimately, financial equity requires providing better direct access to investments. Fractional trading of equities is one approach. Improving retail access to government and corporate debt securities would be another.
The central problem is that fund management is not about investors. It is about smart managers using other people’s money to make money by leveraging their skills. The business continues until they have sufficient capital to exit or close the fund to external investors and allow them to manage their and their friends’ money.