How much does investing in trust-based hedge funds really cost? More than you thought
Trust-based hedge funds, recently officially regulated, offer complex investment instruments to the masses in exchange for collecting 20% of profits. However, one case illustrates that you don't have to be a genius to boost profits for a short time, and when investment managers share only in the profits, a market distortion is created.
The authors are the CEO and a manager at the consulting firm Complex.
Until about two weeks ago, Leopold Aschenbrenner was considered an investment genius. The former researcher at OpenAI founded the hedge fund Situational Awareness in 2024, which focused on artificial intelligence investments. The fund's asset value grew at a dizzying speed to $45 billion and yielded an astronomical return of 439% from the beginning of the year until June.
However, in July, the fund plummeted sharply by 67%. It turned out that the high returns were due to concentrated bets and huge leverage of up to 4 times. Following this, sharp declines in the markets led to a collapse in portfolio value and forced selling.
You don't have to be a genius
Whoever invested $100 in the fund at the beginning of the year reached about $539 at the end of June. After a 67% drop, they were left with about $178. That is, the fund still yielded about 80% from the beginning of the year. However, those who entered at the end of June following the high returns lost two-thirds of their money in a month.
Similar cases have occurred throughout history. The most prominent is that of the LTCM fund, which generated high returns at the end of the last century using huge leverage. But when Russia announced a surprise default in 1998 and the market plummeted, LTCM lost 44% in a month and could not close the huge positions it held. Finally, the Federal Reserve was forced to establish a consortium of commercial banks that injected capital, took over the fund, and prevented a market collapse.
The lesson is that exceptionally high returns do not necessarily stem from investment genius, but sometimes stem from leverage and excess risks. Leverage is a double-edged sword, which not only increases returns when the market rises or bets succeed, but amplifies losses rapidly when the direction reverses, and shortens the time an investor is allowed to be wrong before being wiped out.
The reason for this is that when a leveraged portfolio drops, lenders demand additional collateral and force the sale of assets precisely when prices are low and liquidity disappears. Thus, asset prices plummet further, pressure increases, and a destructive cycle of losses is created.
Tips for investors in trust-based hedge funds:
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Beware of excessive leverage: large profits for a short time can quickly turn into losses.
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Look at the returns: if the fund is new, look at the returns of the assets it invests in.
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Pay attention to the frequency of management fee payments: aim for the lowest payment frequency possible.
The manager shares only in the gains
Trust-based hedge funds were launched in Israel in April 2023 as a temporary order, to allow the public access to strategies that were previously reserved only for institutional bodies and qualified investors, within a regulated shell of a trust fund. Since then, the market has grown and currently manages about 5.7 billion shekels.
Now, the Knesset has approved legislation that turns the temporary framework of trust-based hedge funds into a permanent arrangement, and is expected to accelerate public investment in them. However, the new legislation does not only make new investment strategies accessible to the public, but also a different compensation structure than that practiced in regular trust funds. While in a regular trust fund the manager collects only fixed management fees from the assets, in a trust-based hedge fund the manager also collects success fees derived from the return.
Admittedly, the Israel Securities Authority's instructions include important protections for investors. Success fees are calculated individually according to the price at which each investor entered, it is possible to set an annual return rate above which success fees are collected, and a mechanism according to which in case of losses, the manager will not be entitled to success fees until the fund returns to the previous peak.
However, the manager can still collect high success fees when the fund rises, without returning them to investors during declines. This creates an asymmetric incentive for managers to establish funds, take risks using high leverage to increase volatility and returns during gains that will generate success fees, without bearing the risk of losing the success fees when the risks materialize.
For illustration, assume a fund starts at a value of 100 shekels and rises to 150. The fund manager collects 20% of the profit, 10 shekels, and the investor is left with 140 shekels. If the fund drops afterwards by 50%, the investor is left with 70 shekels, a loss of 30% of their original investment, but the 10 shekels the manager received will remain with them.
This is not a theory. A study by Itzhak Ben-David, Justin Birru, and Andrea Rossi, published in June this year in The Review of Corporate Finance Studies, found that 60% of the profits for which success fees were collected in hedge funds disappeared later due to losses. As a result, the effective success fee rate collected by managers reached about 50% of the investors' profit, and not 20% as set in the terms of most funds.
Supervision is not insurance
The new law grants the Israel Securities Authority the authority to set the complementary rules in aspects of leverage and protections for investors. In our opinion, it is critically important to set rules that will create transparency and identity of interests between investors and managers.
On the other hand, from the investors' side, it is essential to internalize that regulatory supervision is not a warranty certificate. The risk is that the regulatory shell will become the strongest marketing tool of the funds to the public and will dull the risk.
First, it is required to examine in depth the level of leverage inherent in the fund. Leverage is not necessarily a loan the fund takes, but can be created using derivatives and short sales, which create complex and variable leverage.
In addition, it is appropriate to examine the historical performance and maximum drawdown of funds in the past, to illustrate the risk. In the near future, since it is still the beginning of the road for many funds and after years of a rising market, it is advisable to estimate the potential loss of the portfolio composition in extreme scenarios of a sharp decline in the markets.
Finally, one should examine the frequency of success fee payments to the manager and the identity of interests resulting from this. Today, the manager might receive payment during periods of gains in the fund, even if the profits are wiped out afterwards.
In our opinion, it is advisable to invest in funds where success fees will be paid after as long a period as possible. Collecting success fees at a high frequency will turn the funds into a money printer for managers during gains and leave the bill for the public alone during declines. In our opinion, since these are public investors and not institutional bodies and owners of bargaining power, this is a central issue where regulation is required from the Israel Securities Authority. Expanding investment options for the public is a worthy goal, but it cannot end with making hedge funds accessible, without the protections and bargaining power of large and sophisticated investors.
The factors in this column may invest in securities or instruments mentioned in it. The above does not constitute investment advice or marketing that takes into account the data and special needs of each person.
