Last week, losses made by a hedge fund made news in some business and investing media in the US. For once, no one was hyping up anything and creating news where there was none--this particular hedge fund really had made newsworthy losses. Over a period of just about three weeks, a fund called the Carnassie Fund appears to have lost almost all the money it had. I know that sounds absolutely amazing, how can a fund lose 'all' money? And that too in just three weeks? But it's true.
At the beginning of the 2015, this fund had total investor's funds of about US $ 60 million (Rs 368 crore). Last week, after a series of losses, this was down to $ 200,000 (Rs 1.2 crore)! That's a loss of 99.7 per cent over perhaps fifteen days of trading. While American hedge funds are capable of a lot of strange things, this kind of a loss seems to be unprecedented. Even in the worst stock market declines of the 2007-08 financial crisis, no fund turned in such amazing losses.
There are a few things to observe about this Carnassie Fund, which will be of interest to Indian investors. One is of course is that a hedge fund. A hedge fund, specially a US hedge fund is nothing like a mutual fund. In a hedge fund, the fund managers charge a fund management fee which is generally of the order of two to three per cent. However, hedge fund managers also take a share of the profits by charging a huge amount, generally 15 to 25 per cent of the returns generated. Moreover, they effectively skim from the top by deducting the success fee every year.
The pattern of charges effectively means that they share in the customer's profits but not in losses. This means that they are incentivised to take large risks to generate profits since they don't share losses. Larger risks increase the probability of occasionally making large profits. Thus, even quite risky behaviour that may well be in the business interest of a hedge fund. In this sense, hedge funds are in fact quite similar to Portfolio Management Schemes that operate in India. The 'heads I win, tails you lose' pattern of charging the customer is found in India (at least legally) only with the various Portfolio Management schemes run by banks and brokerages.
However, even though one would think that no individual investor would act as foolishly as this fund manager did, I've heard of many who have done so and have made comparable losses on their own account. The explanation offered by Owen Li, who was managing the investments in the hedge fund offers a clue. He said in a letter he wrote to investors that he had made a series of aggressive transactions to make up for poor performance in December. He said he bet on stock price options, with the assumption that the markets would rise but they fell, causing the losses. Clearly, the culprit here is not the wrong bet--which millions of investors make. Instead, it's the aggressive use of options. Every such tale of sorrow one hears in India too involves someone not understanding that derivatives are a bomb which can explode in the hands of an investor who doesn't understand them.
However, one thing that struck me in the news about this fund's collapse was the fund manager's letter that was quoted in the media. In a letter that Li wrote to his customers, he said that" I take responsibility for this terrible outcome," and that "My only hope is that you understand that I acted in an attempt - however misguided - to generate higher returns for the fund and its investors. But even so, I acted overzealously, causing you devastating losses for which there is no excuse...".
I would actually say that as an observer of the Indian investments industry, I find the apology even more surprising than the losses. I've seen a lot of terrible advice and actions from Indian managers, brokers and advisors, but I've never, ever heard of one taking responsibility for his losses caused by his actions and actually apologising!
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