Hedge Fund Fees

Management and Incentive Fees

Hedge fund fees are usually two-fold: management fees and incentive fees. For example, a “2 and 20” fee structure bills a client 2% of funds under management as an annual fee and takes 20% of the annual returns to the fund.

High-water Mark

A “high-water mark” fee structure refers to the practice of charging incentive fees only on returns above the historical highs for the fund.  This cushions investors from being charged more than once for the same performance after a downturn in the value of the fund.

Example: Hedge fund fees

Let’s now use an example to illustrate this concept.

ABC Hedge Fund has $100M in assets under management at the start of period 1.

• The fund grows to $120 million at the end of period 1.
• At the end of period 2, the fund’s value falls to $90M.
• Period 3 final valuation for the fund’s assets is $140M.

If incentive fees are not calculated based on net management fee, calculate the return to investors at the end of each period given a “2 and 20” fee structure with a high-water mark provision for incentive fees.

Period 1

Fund growth = $120M – $100M = $20M

Management fee = 2% of assets under management × $120M = $2.4M

Incentive fee = 20% of growth in fund value = $20M × 20% = $4M

Total fees for period 1 = $2.4M + $4M = $6.4M

Return to investors = ($20M – $6.4M)/$100M = 13.6%

Period 2

Fund growth = $90M – $120M = –$30M

Management fee = 2% of assets under management × $90M = $1.8M

No incentive fee will be taken since the fund has not reached the high-water mark of $120M

Total fees for period 2 = $1.8M 

Return to investors = (-$30M – $1.8M)/$120M = -26.5%

Period 3

Fund growth = $140M – $90M = $50M

Management fee in period 3 = 2% of assets under management × $140M = $2.8M

Management fee = 2% of assets under management × $140M = $2.8M

Growth over high-water mark = $140M – $120M = $20M

Incentive fee = 20% of growth above high-water mark = $20M × 20% = $4M

Total fees for period 3 = $2.8M + $4M = $6.8M

Return to investors = ($50M – $6.8M)/$90M = 48%

Total for the 3 periods

This example shows that the fund has grown during these 3 periods by ($140M -$100M)/$100M = 40%.

What we don’t see, which is typical of hedge funds, is that management has taken $2.4M + $4M + $1.8M + $2.8M +  $4M = $15M from returns for compensation.

The same investment in an ETF with low (let’s say zero, for the sake of example) management fees would’ve returned ($140M + $15M – $100M)/$100M = 55% to the investor.

We can see that management fee, even with high-water marks, has a strong impact on returns. The strategies used by hedge funds are often more commission-intensive than typical buy-and-hold strategies. Although these investment vehicles offer great diversification, they can also be very costly to non-savvy investors. As a result, some studies have shown that hedge funds as a whole underperform the market.

Incentive fees net of management fee

Note that the incentive fee could also have been calculated based on the net of the management fee. This would have created an extra step in which we would have deducted the management fee before calculating the 20% incentive fee (as highlighted in italic in the following example). For example, in period 1:

Fund growth = $120M – $100M = $20M

Management fee = 2% of assets under management × $120M = $2.4M

Incentive fee = 20% of growth in fund value minus management fee = ($20M – $2.4M) × 20% = $3.52M

Total fees for period 1 = $2.4M + $3.52M = $5.92M

Return to investors = ($20M – $5.92M)/$100M = 14.08%

This would have increased the investor’s return.

Question

Alpha-Beta Hedge Fund charges a management fee of 2% on assets under management at year-end and a 20% incentive fee. The initial investment is €150 million and the fund earns a 30 percent return in its first year. What are the fees earned by XYZ Hedge Fund if the incentive fee is computed based on the net of management fee? Assume management fees are calculated using end-of-period valuation.

1. €12 million
2. €12.90 million
3. €12.12 million

Solution

The correct answer is C.

Management fee earned by the hedge fund = (€150M × 1.30) × 2% = €3.9 million

Incentive fee based on net of management fees = ((€150M × 30%) – €3.9M) × 20% = €8.22 million

Total fees = €3.9 + €8.22 = €12.12 million

Reading 50 LOS 50d:

describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds