Random Investor Timing

Yesterday, I discussed why looking at returns on a calendar basis can be misleading: 2018’s Q4 sell off made 2019’s year-to-date market returns appear better than perhaps portfolios reflected. A few readers asked for a more concrete example of how that might manifest itself.

Take the example of hedge funds, and how the date an investor starts impacts those in the 2 & 20 community.

There is over three trillion dollars invested across 11,000 hedge funds in the US. Many of these have a “2 & 20” fee structure – industry parlance for a 2% management fee and a 20% performance fee on capital gains (or some variation of it).

Big up years in markets tend to coincide with big (even massive) fees. Those wealth transfers from investors to managers occur each year primarily courtesy of that “performance” fee (a combination of both alpha and beta). It filters into the broader economy, the multiplier effect juicing the country’s financial centers’ real estate, entertainment, travel, even sales at Ferrari dealerships.

But there is one small giant caveat: High-Water Marks.

Performance fees are paid on net gains over high-water marks – namely, the highest value the fund billed previously. Most hedge funds I am familiar with do not: 1) Charge a performance fee on repeated gains, i.e., portfolio drawdowns and recoveries; or 2) Charge a fee on recoveries of losses.

Those performance fees on this year’s 30% gains this year depends upon when the client started with the fund. In some cases, it could be smaller than you might expect.

You can run through many permutations, but consider investors who put up capital on different dates: The beginning of 2018, versus September 21, 2018 (the peak), versus beginning of 2019. Funds tend to calculate fees either on a calendar or fiscal year basis. Because of that, the fees may vary dramatically.

The most fascinating aspect of all this random timing issues is investor perceptions, and as discussed, Kahneman’s “Peak-end rule.” The S&P is up 10% from its high water mark set in September 2018 highs, which is much less exciting that those 30% gains on a calendar year basis.


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