I am totally confused between the two? Can anyone shed some light?
cpk123
May 31, 2017, 12:35pm
#2
when evaluating a set of managers - if you have a situation that all managers are paid on the net profits of the company - and you had a badly performing division (manager) - but overall company earns a profit - you have to pay the badly performing manager his bonus though he actually was performing at a loss. So you are compensating him for his bad performance based on the good performance of others. (Performance Netting).
Performance netting risk, which applies to entities that fund more than one strategy, is the potential for loss resulting from the failure of fees based on net performance to fully cover contractual payout obligations to individual portfolio managers that have positive performance when other portfolio managers have losses and when there are asymmetric incentive fee arrangements with the portfolio managers. The problem is best explained through an example. Consider a hedge fund that charges a 20 percent incentive fee of any positive returns and funds two strategies equally, each managed by independent portfolio managers (call them Portfolio Managers A and B). The hedge fund pays Portfolio Managers A and B 10 percent of any gains they achieve. Now assume that in a given year, Portfolio Manager A makes $10 million and Portfolio Manager B loses the same amount. The net incentive fee to the hedge fund is zero because it has generated zero returns. Unless otherwise negotiated, however (and such clauses are rare), the hedge fund remains obligated to pay Portfolio Manager A $1 million. As a result, the hedge fund company has incurred a loss, despite breaking even overall in terms of returns.18 Note that the asymmetric nature of incentive fee contracts (i.e., losses are not penalized as gains are rewarded) plays a critical role in creating the problem the hedge fund faces. Because such arrangements are effectively a call option on a percentage of profits, in some circumstances they may provide an incentive to take excessive risk (the value of a call option is positively related to the underlying’s volatility). Nevertheless, such arrangements are widespread.
Performance netting risk occurs only in multistrategy, multimanager environments and only manifests itself when individual portfolio managers within a jointly managed product generate actual losses over the course of a fee-generating cycle—typically one year. Moreover, an investment entity need not be flat or down on the year to experience netting-associated losses. For any given level of net returns, its portion of fees will by definition be higher if all portfolio managers generate no worse than zero performance over the period than they would if some portfolio managers generate losses. As mentioned earlier, an asymmetric incentive fee contract must exist for this problem to arise. Performance netting risk applies not just to hedge funds but also to banks’ and bro- ker/dealers’ trading desks, commodity trading advisors, and indeed, to any environment in which individuals have asymmetric incentive fee arrangements but the entity or unit responsible for paying the fees is compensated on the basis of net results. Typically this risk is managed through a process that establishes absolute negative performance thresholds for individual accounts and aggressively cuts risk for individual portfolio managers at performance levels at, near, or below zero for the period in question.
Distinct from performance netting risk, settlement netting risk (or again, simply netting risk) refers to the risk that a liquidator of a counterparty in default could challenge a netting arrangement so that profitable transactions are realized for the benefit of creditors.20 Such risk is mitigated by netting agreements that can survive legal challenge.
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