This has been a bad year for hedge funds. Many are facing huge redemptions, while others, such as Ospraie’s flagship commodity fund last week, are simply shutting down. You might think this is all down to the credit crunch or market volatility wiping these funds out, but that’s not always the case. I want to take a look for a moment at the possible motives behind some of these closures. They might not be as simple as they first appear…

The power of incentives in an organisation

Tim Harford’s excellent The Undercover Economist looked in great detail at the power of incentives. If a society or an organisation gets its incentive structure right, its people can go on and achieve great things for themselves and for their organisation. If that incentive structure is wrong, people may act in self-interest, which is not always in the best interests of the greater good.

There are, according to economists, three types of incentive:

Financial – if you do this, I will pay you. If you do it well, I will pay you well.
Moral – You should do this because it is the right thing to do. If you do the right thing, you can expect a sense of self-esteem, and approval and admiration from your community. If you don’t, you can expect a sense of guilt, and condemnation or even ostracism from your community.
Coercive – if you do this, physical force will be used against you; you may go to prison.

How the incentive structure works in hedge funds

Let’s look at the (financial) incentive structure behind hedge funds. The strategies funds use vary hugely. Some may deal only in bonds, others in commodities; some may be long-only, while some special situations funds can do pretty much whatever they like.

But one similarity is in the way they charge. There will typically be a small annual management fee (1%-3% maybe) on top of which they take 20% of any profits – but only after making good any earlier losses. More highly regarded managers may charge a higher performance fee.

The idea behind this performance fee structure is that it rewards success, though it has been criticised for giving managers the incentive to take on higher risk and thus higher leverage than they otherwise would.

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But I think the phrase to look at in the current loss-making climate is, “after making good any earlier losses”. What’s called a ‘high-water mark’ is often applied to a performance fee calculation. If a fund launched at £100 and it goes to £150, the manager will receive 20% of that £50 profit - £10. But next year if that fund goes back to £125, no fee is payable.If the following year the fund gets up to £135, still no fee is payable, despite the fund being up. If the next year, the fund goes up to £175, despite that being a phenonomenal performance by the manager, he will still only get 20% of the difference between £150 and £175. The manager has gone two years with no performance fee, then on the third year he only gets a fee of £5 on a £40 move.

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Source: The Real Reason Hedge Funds are Shutting Down