Hedge fund fees are usually two-fold: management fees and incentive fees. For example, “2 and 20” fee structure bills a client 2% of funds under management as an annual fee and also take 20% of the annual returns to the fund. A “high watermark” fee structure refers to the practice of only charging incentive fees on returns above the historical highs for the fund. This avoids charging investors more than once for the same performance after a downturn in the fund’s value.
Let’s now use an example to illustrate this concept.
ABC Hedge fund has $100M in asset 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 fell to $90M. Period 3 final valuation for the Fund’s assets is $140M. If incentive fees are not calculated based net of management fee, calculate the return to investors at the end of each period given a “2 and 20” fee structure with a high-watermark provision for incentive fees.
Fund growth = $120M – $100M = $20M
Management fee = 2% of assets under management x $120M = $2.4M
Incentive fee = 20% of growth in fund value = $20M x 20% = $4M
Total fees for period 1 = $2.4M + $4M = $6.4M
Return to investors = ($20M – $6.4M)/$100M = 13.6%
Fund growth = $90M – $120M = $-30M
Management fee = 2% of assets under management x $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 = -35.33%
Fund growth = $140M – $90M = $50M
Management fee in period 3 = 2% of assets under management x $140M = $2.8M
Management fee = 2% of assets under management x $140M = $2.8M
Growth over high-watermark = $140M – $120M = $20M
Incentive fee = 20% of growth above high-watermark = $20M x 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:
In this example, we can see 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 out of returns $2.4M + $4M + $1.8M + $2.8M + $4M = $15M in compensation.
The same investment in an ETF with low (let’s say zero, for the sake of example) management fees would’ve returned for the investor ($140M + $15M – $100M)/$100M = 55%
We can see that management fees, even with high water marks, have a strong impact on returns. In counterpart, the strategies used by hedge funds are often more commission-intensive than typical buy-and-hold strategies. These investment vehicles offer great diversification, they can also be very costly to non-savvy investors. Some studies have show that hedge funds as a whole underperform the market.
Note that incentive fee could also be calculated based net of management fee.
Alpha-Beta Hedge Fund charge a management fee of 2% based on assets under management at year-end and a 20% incentive fee. The initial investment is €150 million and the fund earns 30 percent return in its first year. What are the fees earned by XYZ Hedge fund if incentive fee is computed based net of management fee? Assume management fees are calculated using end-of-period valuation.
A. €12 million
B. €12.90 million
C. €12.12 million
The correct answer is C.
Management fee earned by the hedge fund = (€150M x 1.30) x 2% = €3.9 million
Incentive fee based on net of management fees = ((€150M x 30%) – €3.9M) x 20% = €8.22 million
Total fees = €3.9 + €8.22 = €12.12 million
Reading 58 LOS 58e:
describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds