July 2, 2019 Joint work with: Ranjan Bbhaduri Ben Djerroud Marcos Escobar Vincent Höhn Fei Meng David Saunders Mohammad Shakourifar Rudi Zagst Postmodernism in Investments: Negative rates… negative fees? Luis Seco University of Toronto RiskLab Sigma Analysis & Management Ltd. Risk Management Financial Services Banking Insurance Payment systems Asset Management The business of Risk transfer For $2M fee (10% of the cashflows) $10M payment city dependent dependent $10M payment resort ski The Snow Fund 3 Fund cash flows Assume correlation of 50% between city and resort precipitation. Then Investment parameters: • with 75% probability, both swaps yield opposite flows, Invested amount: $20M and we just collect our fee: Average return: 10% $2M. Volatility: 50% • With 12.5% probability, we Sharpe ratio = 0.2 receive payments from both: $22M. A bad deal • With 12.5% probability, we have to pay both: -$18M 4 2003: A diversified fund We do the same deal in 100 cities and ski resorts Investor Manager in North America Invested 2000 0 Cashflows are independent of each other amount (independent of global warming) Gross investment 200 0 gains Blue Mountain (Toronto) Management fee -20 +20 Mountain Creek (New Jersey) Panorama Mountain Village (Calgary) Investment parameters: Performance Snowshoe Mountain (West Virginia) fee -36 +36 Steamboat Ski Resort (Hayden, Denver) Invested amount: $2BnStratton Mountain Resort (Vermont) Average return: 10% Tremblant (Montreal) Total gains 144 56 Whistler Blackcomb (Vancouver) Volatility: 5% … Profitability 7.2% Infinity Sharpe ratio = 2 … and several others 2009: A concentrated fund Investor Manager Invested amount 2000 0 Gross investment -60 0 gains Management fee -20 +20 Blue Mountain (Toronto) Mountain Creek (New Jersey) Performance Panorama Mountain Village (Calgary) fee 0 0 Snowshoe Mountain (West Virginia) Steamboat Ski Resort (Hayden, Denver) Stratton Mountain Resort (Vermont) Total gains -80 20 Tremblant (Montreal) Whistler Blackcomb (Vancouver) … Profitability -4% Infinity … and several others The Talk on Fees Mutual Funds: 0.5-2% ETF: 5-25 bps Hedge Funds: 2+20 The Talk on Fees Mutual Funds: 0.5-2% ETF: 5-25 bps Passive Active Hedge Funds: 2+20 Scarce 2010: Hurdles Investor Manager Investor Manager Invested 2000 0 Invested 2000 0 amount The fund offers a amount hurdle to investors Gross Gross investment 200 0 investment -60 0 gains If performance is gains 20% when Management performance Management fee -20 +20 fee -20 +20 exceeds 5% Performance Performance fee -4 4 fee 0 0 Total gains 176 24 Total gains -80 20 Profitability 8.8% Infinity Profitability -4% Infinity 2014: The Calpers Syndrome • In 2014, the California Public Employees Retirement System stunned the investment world with the announcement that they were exiting their multi- billion dollar hedge fund portfolios • While the fund had numerous problems, fees paid to hedge funds was announced to be one reason. 2015: A troubled fund Investor Manager Competitors copied our idea Invested 2000 0 and offer cheap snow swaps amount Gross investment 40 0 Swap rates dropped gains from 10% to 2.5% Management fee -20 +20 Investors are no longer happy Performance 4 4 When profitability is low, fee the management fee is huge Total gains 16 24 Profitability 0.8% Infinity The Optimal Fee framework • The Hedge Fund manager will build a portfolio to optimize its own utility: the fee income • The investor can -indirectly- select the fee it pays by choosing to participate in the fund or not • The rational investor will aim for a fee that will optimize its own utility: the return after fees Investors dilemma • Investors are being empowered • Service providers try to innovate • How can investors re-define their role to • Maximize their utility… • … knowing that the managers will seek to maximize only theirs Two utilities Manager Investor Management fee Performance fee Fee Innovation Fund managers are offering performance protection in cash…. …no management fees… … in exchange for higher performance fees. Managers are not investors Managerscheque write the first Fund cashbonds flows look like 2017: A smart fund Investor Manager Investor Manager Invested Invested amount 2000 200 amount 2000 200 Gross Gross investment 100 The manager investment -160 gains finds ways to gains obtain Guarantee 0 0 Guarantee 0 -160 financing: Performance fund leverage Performance fee -50 50 fee 0 0 Total gains 50 50 Total gains 0 -160 Profitability 2.5% 25% Profitability 0% -80% Past, present & future Alignment of Good old times Crisis Reaction Epiphany Investor/Manager interests 180 90 0 ? -90 -180 2003 2009 2010 2015 Good 2017 Bad 2017 Fee negotiation • Performance fees are call options • Guarantees are (covered) put options • Coupon payments are deterministic • In the negotiation of management agreements, fee calculations are needed • Investors use the Black-Scholes framework to calculate the risk neutral value of the performance fee and of the First Loss protection • Managers use a real-world measure of the performance fee and First Loss protection Fee valuation framework The manager’s perspective Investor’s perspective … or receives! Fees as Options: pay-off structures Fee Sensitivities: Volatility Conclusions • Investment Innovation is being produced upon a re- definition of the investor (consumer, client) and manager (producer, service provider) role. • Managers use their equity to provide guarantees to investors, in exchange for a sharing of the gains • It has the potential to create new financial products • These new products require enhanced risk management to oversee new risk profiles: liquidity, transparency and control. • The risk/return characteristics are attractive Thank You.