A Hedge Fund Offers to Share the Risk of Losses

(Bloomberg Businessweek) -- Steve Diggle got rich by trading other people’s money. Now he’s trying to upend the very business model that made him wealthy.

Once co-head of a $5 billion hedge fund that was among Asia’s largest, Diggle quit the industry eight years ago to manage his own money. From the sidelines, he came to recognize that the $3 trillion industry was rigged: Investors were paying exorbitant fees for subpar returns, managers earned huge sums for amassing assets, and traders shared profits with clients but not the losses. As Diggle puts it, there simply wasn’t any logic to the classic “two and twenty” hedge fund fee model, in which managers traditionally charged both a 2% annual management fee and took a 20% cut of profits.

“We lost our way because rather than performance machines we just became asset gatherers,” Diggle says of hedge funds. “If the industry is to go forward, it needs to reinvent itself rather than continue with a flawed model.” To tackle the problem, he gathered colleagues to brainstorm at the offices of his Vulpes Investment Management in Singapore, spending six hours scribbling ideas on a whiteboard. Their solution: Share more of the risk.

He began testing the idea three years ago in a new fund, which now has about $15 million in assets. Under the approach Diggle’s team developed, Vulpes and the fund’s traders bear the brunt of initial annual losses. It works like this: If investors give $1 million to Diggle’s Vulpes Kit Trading Fund and it declines up to an annual 2%, the firm absorbs the $20,000 loss. Investors lose nothing.

Such “first-loss” provisions aren’t entirely new. But Diggle’s added a twist. With deeper declines, investors who prefer low risk, such as pension plans that seek steady returns, shoulder a smaller loss than high-risk investors such as wealthy individuals who are willing to stomach a wilder ride for outsize returns. The high-risk investors take a greater share of profits above 8%. The fund also charges a management fee of 0.75%, comparatively low for hedge fund. It collects a share of profits on a sliding scale—from 15% on the first 10% of gains to 25% after that.

Diggle is stepping in at a time when money managers face a squeeze. In recent years, hedge funds haven’t produced the kinds of returns that they did in their heyday, forcing managers to rethink their business models. Investors have been racing for the exits—since the start of 2016, they have pulled $116.4 billion from hedge funds, the most since the aftermath of the 2008 financial crisis, according to Hedge Fund Research Inc. The fees charged by hedge fund managers have declined, albeit gradually, with the average annual management fee now at 1.4% and the performance fee at 17%.

Meanwhile, asset management behemoths including Fidelity, Vanguard, and BlackRock are slashing fees, in some cases to zero or close to it for index-based products. Hedge fund managers who want to charge a premium price have a lot to prove these days.

Diggle has seen the peaks and troughs of market trading over a career that spans more than three decades. He got his start at Lehman Brothers in the 1980s and co-founded a hedge fund firm, Artradis Fund Management, in 2002. His fund made $2.7 billion in the depths of the global financial crisis; then, after losing money for two consecutive years, Diggle closed it. Vulpes is a family office, meaning it invests the wealth of Diggle and some other high-net-worth clients. It has invested in an array of assets, from German real estate to avocado farms, and now manages about $400 million.

Why aren’t more hedge fund managers cutting costs deeply and sharing risk to attract clients? “The challenge is that if the management fees they charge aren’t enough to support the cost structure, they’ll need to generate alpha consistently,” says Victoria Vodolazschi, investments director at consulting firm Willis Towers Watson in New York. Alpha is Wall Street-speak for market-beating performance. If a hedge fund can earn big gains and get a cut of those profits, it can stay in business even with low management fees. Trouble is, “there aren’t many managers who can outperform consistently,” says Vodolazschi.

Diggle concedes the trading advantage that hedge funds had once enjoyed has declined. As such, he’s banking on allocating money to traders who can try to find profits in obscure, esoteric areas such arbitrage opportunities in Korea or market-making in southeast Asian stock markets.

In its first three years, the Vulpes Kit Trading Fund racked up average annual gains of almost 16% for its investors taking the higher-risk, higher-return option. Now, after his eight-year hiatus from managing money for large investors, Diggle is setting his sights on courting them again. To help in this effort, earlier this year he hired Gavin Gilbert, who had worked at funds including Brevan Howard Asset Management, as his investment chief.

Diggle says he’s had a tough time hiring traders as few are keen to share losses. And he realizes that it’s unlikely much of the industry will join him in his experiment. But he hopes his peers take notice and change before it’s too late. “I believe that we are right about the future of the hedge fund industry and a lot of other people are wrong,” he says. “We need experimentation because the status quo is failing.”

To contact the editor responsible for this story: Alan Mirabella at amirabella@bloomberg.net, Pat Regnier

©2019 Bloomberg L.P.

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