Friday, May 13, 2011

Why Hedge Fund Managers Quit

In 2008 and 2009 there were a number of stories about money managers closing down their funds only to open a new one a short time later. Why would someone do that? Because they have the incentive to do so. Incentives matter. 

Knowing this intuitively, I wanted to help convey that incentive visually so I created the graph below. As you can see, as the losses begin the percentages required to get back to even (in financial pjargon it is referred to as the highwater mark) get higher and higher. Notice the logarithmic scale on the left axis.

Percentages don't speak to everyone so I added a time dimension by creating the right axis. If you assume  that the person could earn 20% (a very good return and well over the major indices' averages) constantly (an even bigger assumption than the return because of the volatile nature of stocks) until they earn back all of the loss then for a given % loss on the x-axis you can see how many months it would take to wait for the recovery on the y-axis. As the chart indicates, if a hedge fund manager loses 15% of his (your)  assets, without considering another gyration in the market it would take a manager a full year to reach the highwater mark. A 36% drop, which is similar to what investors witnessed for the full 2008 calendar year, would take three full years to recover. The highwater mark is particularly important in the hedge fund world, because they often have a rule in their contacts which requires them to get back to the highwater mark in order to earn the management fee (usually 2% of assets which is substantial for large funds).

So, facing no possibility of fees in the near future and with the possibility of things taken another downward turn the manager has the incentive to take a rational (not the most moral) step - close down the current fund that is below the highwater mark and create a new fund where he can start getting paid immediately.


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