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Hedge Funds' Win-or-Die Bet

Offering to cover investors' losses is an attractive marketing strategy, but a threat to firms' survival.

It had already become one and 20. Now, you can invest in some Asian hedge funds for zero fees upfront and they'll cover any initial losses. 

The institutional asset management industry saw net outflows of $167.1 billion in the fourth quarter, according to hedge fund tracker eVestment. That's prompted some contemplation and even penance in the industry, with a number of shops, especially new ones, abandoning traditional fee structures.

It was high-time money managers gave up on charging a 2 percent fixed fee and 20 percent of returns above a certain threshold, the so-called 2-and-20 model. That said, some people may be taking it too far.

Asian manager Noviscient, founded by Scott Treloar, plans to start a fund that will charge investors no management fee and will absorb the first 5 percent of annual investment losses, Bloomberg News's Klaus Wille and Bei Hu reported Friday

You read that right. Granted, the fund, which uses computer models to trade stocks, futures and currencies, will charge 20 percent of gains on the first 10 percent of profits, and half of whatever it makes above that.

Few, and Plenty

Noviscient's hedge fund model builds in a few downside risks and gives its management plenty of upside

Source: Bloomberg

That's the catch. A 50-50 share on profits above 10 percent is a lot. Here's the problem, though: Hedge funds seldom make returns exceeding that level. I'm not suggesting Treloar can't. It's just that hedge funds make far less than that on average. In the past decade, they've often lost money. 

Chasing Mirages

In the past decade, average returns on hedge funds seldom beat 10 percent

Source: Hedge Fund Research Indexes; Bloomberg

Take macro funds, which bet on interest rates and currencies -- one of the areas where Noviscient is active. Since 1998, the Hedge Fund Research Macro Index returned more than 10 percent on only three occasions. The last time was 10 years ago, when it logged 11.11 percent.

Under Noviscient's proposed system, an investor with $100 million in an average fund in 2007 would have paid roughly $2.6 million in fees. That's not much different from what would have been paid under a traditional charging structure. When the going's good, there's not much to be gained from betting on Noviscient versus any other manager.

Macro funds have had negative returns in four of the past 10 years, though. The worst was 2011, when they were down 4.2 percent. If Noviscient had been operating a macro fund under its new fee structure, it would have forked out $4.2 million to make up the losses on a $100 million investment. Awesome for the investor, not so good for Noviscient.

Recipe for Disaster

Under Noviscient's new fee structure, the average macro hedge fund would have netted $2.2 million in fees since 2006 and recompensed investors for losses in three consecutive years

Source: Bloomberg

The marketing strategy plays to a fundamental bias of investors: aversion to low-probability small losses, even when accepting that risk offers a higher expected payoff. This was demonstrated in 1979 by Daniel Kahneman and Amos Tversky, the developers of prospect theory. So telling people they will seldom lose is a great way to get them to commit money.

If the new fad catches on, it's easy to see how hedge funds will start attracting money again. That doesn't mean they'll survive, however. Unless every manager is a genius who can always make positive returns, fund closures will only accelerate. 

It's right for hedge funds to stop charging investors extraordinary sums for often-ordinary returns. But mortgaging the house to attract investments can't be the solution either. 

Tim Culpan contributed to this column.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at

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    Matthew Brooker at

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