“An investment entity need not be flat or down on the year to experience netting-associated losses”
(Institute 151)
Institute, CFA. 2017 CFA Level III Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives. CFA Institute, 07/2016. VitalBook file.
Can someone explain what does this mean?
It just means that an investment could be in any position (UP (Profit making), Flat (0 profit) or DOWN (Loss making)) but because you are doing Netting - you could end up with Net Losses.
Read in context of the whole paragraph and it should be self explanatory (along with the example in the previous para)
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.
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.