9.3 Fund Management

Fund Management

FMP–3 is about pooled investment vehicles: who can redeem when, at what price, with what fees, and with what risk transfers between managers and investors. Banks and insurers appear as sponsors and counterparties; the products themselves reshape market liquidity and systemic risk when leverage and redemption terms misalign.

Open-End, Closed-End, and ETFs

Net asset value (NAV) = (assets − liabilities) / shares outstanding. For an open-end fund, investors buy and sell with the fund at NAV (subject to cutoffs and possible fees). Closed-end funds can trade at a premium (price > NAV) or discount (price < NAV) for long periods because you cannot force the fund to redeem at NAV. ETFs usually stay tight to NAV because creations/redemptions in-kind (or cash) let arbitrageurs correct gaps—unless underlying markets are illiquid or volatile.

Worked NAV example

A fund holds securities worth $505 million, has liabilities of $5 million, and 20 million shares outstanding.

NAV = (505 − 5) / 20 = $25.00 per share.

If markets gap and assets fall to $485 million the next day with the same liabilities and share count, NAV = 480 / 20 = $24.00. Open-end redeemers receive that day’s NAV (per prospectus timing rules); closed-end holders get whatever exchange price clears, which might be $23.40 (a 2.5% discount to NAV) in a risk-off tape.

Undesirable Trading Behaviors

Open-end structures create conflicts between redeeming shareholders and remaining shareholders when:

• Market timing exploits stale NAVs (especially in international funds priced on lagged closes).
• Late trading (illegal when after-cutoff orders receive same-day NAV) advantages insiders.
• Liquidity mismatch: daily liquidity offered on portfolios of illiquid assets forces remaining investors to bear transaction costs and fire-sale discounts when others exit.
• Soft-dollar / excessive trading can enrich brokers or managers at investors’ expense.

Fair-value pricing, redemption fees, gates/side-pockets (more common in alternatives), and swing pricing are tools to protect long-term holders. For FRM, connect the behavior to the victim (remaining shareholders) and the control.

Hedge Funds Versus Mutual Funds

Hedge funds sell flexibility and absolute-return aspirations; mutual funds sell regulated, liquid, relative-return products. Neither label guarantees performance. Leverage and illiquidity in hedge funds create investor liquidity risk and prime-broker / funding risk that mutual funds usually avoid.

Incentive Fees: Hurdle, High-Water Mark, Clawback

A common structure: management fee on AUM plus incentive fee on profits.

• Hurdle rate: incentive fees accrue only on returns above a stated rate (soft hurdle: fee on all profits if hurdle cleared; hard hurdle: fee only on profits above the hurdle—know which version a question specifies).
• High-water mark (HWM): no incentive fee until NAV exceeds the previous peak on which fees were paid—prevents double-charging for recovering losses.
• Clawback: especially in private equity, mechanisms to reclaim incentive distributions if early winners are offset by later losers over the fund life.

Worked incentive-fee example (with HWM)

Start-of-year NAV = $100. Incentive fee = 20% of profits above HWM; HWM starts at $100. Ignore management fees for clarity.

Year 1: NAV before fees rises to $120. Profit = $20. Incentive fee = 0.20 × 20 = $4. End NAV after fee ≈ $116. New HWM = $116 (conceptually the peak after fee crystallisation—questions may define HWM on pre- or post-fee NAV; follow the stated convention. Here we treat HWM as $116 post-fee).

Year 2: NAV falls to $110 (before fees). Below HWM → no incentive fee. Investors are recovering prior peak.

Year 3: NAV rises to $130 before fees. Profit above HWM = 130 − 116 = $14. Incentive = 0.20 × 14 = $2.80. After fee ≈ $127.20; HWM updates.

Soft hurdle sketch

If a 5% soft hurdle applies on a $100 start and NAV goes to $112 (12% return), the hurdle is cleared; with 20% incentive on all profits, fee = 0.20 × $12 = $2.40. Under a hard hurdle, fee applies only to 12% − 5% = 7 points → 0.20 × $7 = $1.40. Soft versus hard changes fee drag materially.

Strategies and Risks

Common hedge-fund strategy families and signature risks:

Many “arbitrage” labels hide tail risk: small steady gains, rare large losses when spreads blow out and leverage forces deleveraging.

Performance Biases

Reported hedge-fund index returns can look better than live investor experience because of:

1. Survivorship bias — dead funds drop out; averages exclude their poor returns.
2. Selection / self-reporting bias — only funds that choose to report appear in databases.
3. Backfill (instant history) bias — strong early track records are added retroactively when a fund starts reporting.
4. Smoothed / stale valuations — illiquid marks understate volatility and overstate Sharpe-like ratios.
5. Liquidation bias — final death returns may be missing or incomplete.

Risk managers adjusting peer comparisons must haircut headline Sharpes and correlations. Diversification benefits versus hedge-fund indices often shrink after bias corrections and in crises when correlations spike.

Putting Fund Management Together

An open-end bond fund offering daily liquidity on concentrated high-yield holdings is a liquidity mismatch story. A hedge fund advertising a 2-and-20 fee without HWM after a 40% drawdown is an incentive design story. An index of self-reported macro funds with a 1.8 Sharpe almost surely embeds performance bias. FMP–3 tests whether you can name the vehicle, the fee rule, and the bias—not just recite “hedge funds are unregulated.”