Hedge Fund Fees
One important item that none of the definitions covered
was hedge fund fee structures, which is, in my opinion,
a key distinguishing feature of hedge funds versus in
particular mutual funds. Hedge funds almost always have
a fee structure that includes both a fixed fee and a
management fee. The fixed fee usually ranges between
1 and 2% of assets under management and the management
fee ranges between 20 and 25% of upside performance.
As hedge funds are unregulated, these ranges are often
exceeded, and can be as high as 5% fixed fee and 25%
management fee. Hedge fund fees are often quoted in
language such as "2 and 20" meaning 2% fixed
fee and 20% management fee. There are two additional
important points about hedge fund fees:
- the benchmark
- high water mark
The performance fee is sometimes calculated net of
a benchmark. That is, the returns that fees are paid
on are sometimes only those returns in excess of some
benchmark. Sometimes the benchmark is a risk-free
interest rate such as LIBOR (often called the cash
benchmark, meaning performance fees are paid on the
profit that would be made in excess of an investment
in cash) and other times it is a market index such
as the MSCI World Index or the S&P 500 index.
Example: Suppose at the beginning of year 1 a hedge
fund has a net asset value of 100, and throughout
the year the fund realizes a 25% return, raising the
net asset value to 125. Then if an investor entered
the fund with a $1,000,000 investment at the beginning
of year 1 then his or her "shares" would
be worth $1,250,000 gross of fees. If the benchmark
was cash, say 5%, then the fees would be paid on the
$200,000 upside in excess of cash. That is, the first
5% of the return would not have to have fees paid
on it. If the fees were 2 and 20, then the investor
would pay $20,000 in fixed fee (2%) and 20% of the
upside above cash, that is, an additional $40,000
for a total of $60,000 in fees. This would make the
investment value, gross of fees, equal to $1,190,000.
The high water mark is an important concept: investors
in hedge funds enter the fund at a certain net asset
value, which we'll call the entering NAV. If the fund
loses money in a given year and then makes back that
money in a subsequent year, the investor is usually
not required to pay a management fee on any portion
of the upside in the subsequent year that was below
the entering NAV.
Example: Suppose an investor enters a hedge fund with
a $1,000,000 at the beginning of year 1, and in that
year the fund is down 20%, that is, the value of the
investment drops to $800,000 gross of fees. The investor
still pays the management fee (that is why it is called
a fixed fee), but the investor pays no management
fee. Now suppose that after year two the investment
value is up to $1,200,000, representing over a 30%
gain in year two for the fund. The investor, nevertheless,
only pays a management fee on $200,000, that is, he
or she only pays a fee on the amount in excess of
the entering NAV. The entering NAV in this case is
called the high water mark. In subsequent years if
there is a drop in NAV, the new high water mark will
be the entering NAV of the previous year, or the previous
high water mark, whichever is greater.
Credit should be given to Neil
A. Chriss as some of these references are a compilation
from a lecture series.
