Risks of joint investments

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FT editor Roula Khalaf selects her favorite 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 the rich and big ones, are more equal. This derives, in part, from the pooling structures—mutual funds, unit trusts, limited partnerships or equivalents—through which the investments are held.

These structures facilitate access to specific assets, investor participation, economies of scale and professional management. There is an economic trade-off between profits and additional expenses. But pooling creates more risks.

First, the interests of investors and asset managers are difficult to align. Management fees are for the assets under management, focusing on attracting inflows rather than returns or risk.

Performance fees create asymmetric payments for the manager. Assume a $100 million fund where the manager has a $5 million interest in the fund (“skin in the game”) and fees are 1% of AUM and 20% of performance fees – a share of the investment return , usually over a landmark. If the hedge fund loses $20 million, the manager loses $1 million, offset by the management fee received. If the fund earns $20 million, then the manager earns $4 million plus the management fee ($1 million) – a 100% return.

Conflicts influence changes in the risk profile. If a fund is performing well, the asset manager can reduce the risk of lock-in returns, especially near reporting dates. Underperforming fund managers can increase their risk when faced with the withdrawal of investors’ funds.

Attempts to align interests have perverse results. Strict mandates around narrow targets can discourage staying uninvested when opportunities are unavailable or expensive, but also make it harder to liquidate to reduce risk (due to specifying asset composition). Performance benchmarks lead to “closet indexing” or “herding behavior”, which averages the returns.

Second, mutual investments periodically value the investments in the fund. There are well-documented difficulties due to liquidity problems in traded assets and, of course, non-traded private assets. Valuation errors transfer real value between investors who buy and sell and distort the values ​​of assets and collateral. 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 assessments. More than half of all changes in AUM come from performance, mainly changes in market value, not new entries.

Third, there are known asset (core investment) and liability (redemption) mismatch issues. However, pooled structures that combine investors’ funds create exposure to “weak hands”. Investors who do not need liquidity and have the ability to withstand short-term downturns are exposed to co-investors who need to redeem. This can force funds to sell holdings, usually the better and more liquid assets, to raise cash, which affects the fund’s return and risk. Fixed-term funds or lock-in periods lead to a pool of redemptions, exacerbating exit risk.

Fourth, mutual funds come with built-in cash or liquidity risk. Many private market funds are structured with cash calls, contractual commitments to contribute when needed. This creates cash flow risks for investors. Fund distributions are also often unpredictable, resulting in uncertain cash flows and tax consequences.

While smaller investors have no choice, high net worth individuals and family offices increasingly prefer managed accounts or exclusive dedicated structures where their funds are not commingled with other investors to minimize these risks.

Regulatory proposals to tighten the rules on liquidity buffers and pricing may address some concerns. Other initiatives could include eliminating fees on AUM resulting from unrealized asset price increases, forcing income distributions unless investors specifically choose to reinvest, and more flexible rules on redemptions or penalties. Finally, financial equity requires ensuring better direct access to investment. Fractional stock trading 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’s about smart managers who use other people’s money to make money by leveraging their skills. The business continues until they have enough capital to exit or close the fund to outside investors and allow them to manage their money and that of their friends.