April 2022
Can’t be late
Short-term shorts only please
Think we will see more of this?
Justin Wolfers on peaking inflation
Gabe, what the ??!!!
Imagine a hedge fund manager that charges investors a performance fee of, say, 20% of profits. Performance fees align the manager’s incentives with those of investors, and plenty of investors prefer performance fees versus fixed management fees that are charged regardless of whether or not the manager delivers attractive performance. But there’s a problem:
The fund’s portfolio goes up, say 10%
The manager charges the 20% performance fee (20% of 10% = 2%) on those profits
The fund’s portfolio goes down, say to the original level before charging the performance fee
No performance fee is charged on the way down since there are no profits
The fund’s portfolio goes up, say 10% again
The manager charges the 20% performance fee (20% of 10% = 2%) on those profits
Investors don’t like being charged the performance fee twice on the same profits. So they demand a high water mark, which is a mechanism that requires managers to deliver returns back to the highest prior level on which a performance fee was charged before resuming the charging of performance fees. Similar to double taxation, the high water mark ensures that performance fees are not charged twice on the same performance.
This isn’t to say that losses are more acceptable to investors - it’s just that those losses are not made worse by the imposition of additional performance fees. Investors can still withdraw from the underperforming manager without giving them the chance to recover to the high water mark, that’s the nature of this performance-driven industry. Or, investors could perhaps negotiate new, more investor-favorable terms with the manager in exchange for keeping their monies in the fund while the manager tries returning to the high water mark.
When managers underperform, the high water mark requires them to make up for that underperformance. That’s beneficial for investors. But what about the manager that is now working for free (or collecting only a smaller management fee) until they return to the high water mark? Conventional wisdom would say that sometimes working for free comes with the territory of charging those previous performance fees. Managers know that markets go up and down, so they should prepare in the good times for the inevitable rainy days when they need to return to the high water mark before collecting additional performance fees.
Unfortunately for those managers, however, their team members may not be willing to ride out those rainy days, particularly when the fund is deeply underwater and those team members can switch to a different hedge fund and perhaps reset their compensation baseline. Sure, it may be difficult to convince another hedge fund to hire them after underperforming, but that underperformance can be attributed to others on the team or countless other viable explanations. From the manager’s perspective, the previously-aligned incentives have swung against them, and they now must provide some incentives for their teams to resume delivering positive returns back to the high water mark, or else lose those team members entirely. What to do?
Well, Gabe Plotkin at Melvin Capital who infamously lost a bunch of money by shorting GameStop during the meme stock mania of early 2021, is now asking investors to withdraw their money and reinvest in a new fund that he will run, thereby resetting the high water mark to zero so he can resume charging them performance fees:
Melvin Capital, the embattled hedge fund run by its once high-flying founder Gabe Plotkin, has been discussing a novel plan with its investors under which the firm would return their capital, while giving them the right to reinvest that capital in what would essentially be a new fund run by Plotkin.
Under the terms being discussed, Plotkin would unwind his current fund at the end of June. That fund was down 21% at the end of the first quarter.
Plotkin would then start what would essentially be a new fund on July 1 with whatever money his investors decided to reinvest, but he would do so without having to bring those investors back to even on their invested capital before he could earn a performance fee.
This so-called high water mark, which requires hedge fund managers to return their investors’ capital to par prior to earning fees, is virtually impossible for Plotkin to meet on much of the capital in Melvin, given the fund’s losses of 39% last year and at least 21% so far this year. Plotkin plans to charge performance fees of 15%-25% for the newly formed fund.
What investors would go for this? Like, the whole point of investors demanding a high water mark is for cases like these where their managers previously collected performance fees but then lost a bunch of money. Why would those investors just reset the high water mark? Particularly for a manager who just lost them a bunch of money?
I also wondered whether the new fund would offer a high water mark to investors. The obvious answer is, umm, yes? What’s the worst that could happen? Once you have closed your fund to get out of a previous deeply underwater performance gap, if the same thing happens in the second fund, well, just close that fund and reopen a third one? Investors would know your history though, so any investor in the new fund should be okay without a high water mark. So the obvious answer is, umm, no?
Well, we never got to find out, because shortly thereafter, Melvin Capital Management Scraps Plan to Start Charging Performance Fees Again (WSJ). Investor backlash clearly made the decision easy, it would have been impressive if Plotkin could have pulled this off.
Here’s more from the same CNBC article Embattled hedge fund Melvin Capital weighs unwinding current fund to start new one, sources say:
Plotkin, according to people familiar with his plans, has committed to keeping his “new” fund at or below $5 billion in capital and returning to a focus on shorting stocks, a talent for which he was known for many years prior to suffering significant losses during the meme stock craze of early 2021.
Perhaps his chances would have been better if his new fund offered a different thesis from the one that burned him? You know my views on this, stock picking is a losing game and shorting is a tough way to make a buck. Plotkin made multiple short bets from 2014 to 2020 that paid off handsomely and attracted billions in new capital, but in all Likelyhood was the result of an unreliable strategy in a losing game that inevitably regressed to the mean and cost him everything. Judging his track record by the outcomes rather than the process (what Annie Duke calls Resulting) cost investors dearly also. Why those same investors would willingly reset their high water marks so the same manager can engage in the same strategy that produced this deeply underwater outcome, I will never understand.
What card counting can teach us about variance
I love to ask the question “What can ______ teach us about _____ ?” When we encounter a less-familiar context, the use of metaphor can help us relate that less-familiar context to a more-familiar context and bring out the similarities and differences in an understandable way. Here are other iterations of this question:
What can beating the dealer teach us about beating the market?
What can NFL and NHL statistics teach us about the Stock Market?
What can the World Chess Championship teach us about investing?
Time again to add to this list:
What can card counting teach us about variance?
The context of blackjack readily relates to investing. Plenty of gamblers lack an edge and in the long run lose to the house edge. Likewise, plenty of investors lack an edge and in the long run lose to psychological biases, flawed strategies, and fees, to name a few. Learning to overcome these negative impacts on investment returns is very possible, evident in reliable processes employed successfully over long time horizons, and in some ways is akin to how card counters create an edge against casinos.
Colin Jones at Blackjack Apprenticeship recorded this video Variance Explained: Why Card Counters Can Lose So Much. The mathematical content is fundamental and solid, regardless of the context. I want to share two particular insights that relate to variance, which is the structural fluctuations in returns, in both positive and negative directions, that every investor experiences and must make sense of.
When you are winning, remember that those wins are needed to offset the inevitable losses as the law of large numbers plays out toward your long term expected value (EV).
When you are losing, remember that those losses likewise are necessary and will offset excess gains as the law of large numbers plays out.
In both cases, the prudent thing to do is reflect on and stress test your process to ensure that gains are not due to taking excess risk and that losses are not due to flawed execution. Once your strategy and process is affirmed, then you can confidently continue playing while the variation works itself out and you converge toward your expected value in the long run.
Public Service Announcement - the worst and best days
As inflation is taking its grip and investors are bracing for the unknown effects of central banks tightening monetary conditions, this is a reminder from the American Association of Individual Investors: Don't Let Fear Cause You to Miss the Best Days in the Stock Market.
History has shown the best days to be in the market tend to occur very close to the worst days. More importantly, if you miss those best days because you were out of the market on concern about what might happen, you will forfeit a large amount of wealth.
…
“If you stayed invested in the S&P 500 from the start of 1928 through March 9, 2022, you would have earned 23,987.2%. If you were out of the market for the 10 worst days over that period, you would have seen your return increase to 26,525.8%. Perhaps most surprising, though, was the impact of missing out on the 10 best days. Sitting on the sidelines for 0.04% of the days over this period would have dropped your return to 7,864.5%.”
ONE MORE THING…
Can’t be late. Investors that are only now looking to buy protective puts are late to the party - and will need to pay up for that protection. Rumbling in Options Market Is Sound of Traders Rushing to Hedge - Bloomberg
Short-term shorts only please. Betting against American business will not work in the long run. Short sellers are starting to bet against America's economy - CNN
Think we will see more of this? NFTs losing most of their value? Absolutely. An NFT of Twitter co-founder Jack Dorsey's first tweet has lost almost all of its $2.9 million value and Why Jack Dorsey's First-Tweet NFT Plummeted 99% In Value In A Year
Justin Wolfers on peaking inflation. Some simple arithmetic explaining why core inflation has likely peaked. Some simple arithmetic explaining why core inflation has likely peaked.
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