Returns of Alternative Investments

Hedge fund fees are often split into two categories: management and incentive fees. A “2 and 20” fee structure, for example, charges a customer 2% of the funds under management as an annual fee and keeps 20% of the fund’s annual profits.

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 the 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

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 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 this example) management fees would’ve posted the returns illustrated below  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. 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 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

Assume that XYZ Hedge Fund has €150M in assets under management at the start of period 1. The fund grows to €200 million at the end of period 1. If incentive fees are not calculated based on net management fee, the return to investors at the end of period 1 given a “2 and 20” fee structure is closest to:

1. 20%.
2. 24%.
3. 25%.

Solution

The correct answer is B.

Fund growth = €200M – €150M = €50M

Management fee = 2% of assets under management × €200M = €4M

Incentive fee = 20% of growth in fund value = €50M × 20% = €10M

Total fees for period 1 = €4M + €10M = €14M

Return to investors = (€50M – €14M)/€150M = 24%