HEDGE FUND BASICS

Many investors are unfamiliar with the way a hedge fund investment behaves.
In addition to having more investment latitude than traditional investment
managers, a hedge fund manager may charge a variety of fees and
place restrictions on exit from a hedge fund.
Fees
Hedge funds charge a variety of fees. Other types of investment pools, including
mutual funds, private equity funds, and real estate investment
trusts, charge the same types of fees, but the structures of the fees may differ
slightly in the hedge fund industry.
A management fee is charged as a flat percentage of assets under management.
Hedge funds generally charge an annual management fee between
1 and 2 percent. For example, if a fund charges 1.5 percent, it might
assess a monthly fee equal to .125 percent (1.5%/12) based on the value of
the fund’s capital at month-end. This fee is charged regardless of whether
the fund has been profitable. Some funds calculate the management fee
quarterly or less frequently.
An incentive fee is based on the profits made by the hedge fund.
Hedge funds generally charge 15 percent to 25 percent of profit as an incentive
fee. Suppose a fund makes 2 percent or $2 million on assets of
$100 million in a particular month before incentive fees but after the
management fee has been deducted. If the fund collects a 20 percent incentive
fee, the fund will pay $400,000 ($2 million × 20%) to the management
company.
Funds usually charge no incentive fee on profits that offset prior losses.
This is called a high-water mark provision. For example, suppose a hedge
fund started with a net asset value (NAV) of $1,000. Over several months,
the NAV rose to $1,500 and the management company charged incentive
fees based on this return. If the NAV declined to $1,400, the manager
would refund no incentive fees, but the fund would pay no incentive fees
on any returns until the value to investors rose above the previous highwater
mark of $1,500.
Sometimes a fund pays incentive fees on returns above a certain minimum
return. Suppose a $100 million hedge fund pays a 20 percent incentive
fee on returns above the London Interbank Offered Rate (LIBOR). If
LIBOR was 3 percent (annualized to 3%/12 or .25% for a month) and
the fund return was 3.5 percent in one month, the fund would collect an
incentive fee on 3.25 percent; thus, $100 million × (3.5% – .25%) ×
20% = $650,000.
A fund may subject previously paid incentive fees to a look-back provision.
In this case, a manager may be required to refund incentive fees
back to the fund if the fund experiences a loss shortly after an incentive
fee is paid. Look-back provisions are not common, and the specific provisions
can vary from fund to fund. For example, one fund limits the lookback
to three months. Another fund limits the incentive fee look-back to a
calendar quarter.
Hedge fund managers may charge other fees, such as commissions, financing
charges, and ticket charges. The management company may keep
some or all of these fees or may pay out part of these fees as sales incentives
to individuals who market the hedge fund to investors. The existence
and the magnitude of these fees vary from fund to fund. The fund should
disclose these fees to investors, but investors may nevertheless have trouble
determining how much these fees affect the return of the fund.