Jan 28, 2025

Hedge Fund Fees

Hedge fund skeptics often argue that their high fees disqualify them as a legitimate investment option because they represent an obstacle to performance that is too large to overcome. By contrast, hedge fund proponents argue that there is plenty of skill in that segment of the money management business, and if you pay peanuts, you get monkeys. This post discusses hedge fund fees, their structure, and their impact on portfolio returns.

The Fee Structure

The first component of hedge fund compensation, the base fee, is calculated as a percentage of the net asset value (NAV). While hedge funds are reputed for charging 2%, research has shown that the average base fee is 1.5%, which is good news for investors.

The performance fee is computed as a percentage of the value added by the manager. The average performance fee is 19%. In most cases, calculating performance fees is a multi-step process:

  • If a fund’s performance fee must be calculated after accounting for base fees, the latter must be subtracted from the gross profit.
  • Another amount will be subtracted from the gross profit to account for the hurdle rate. While hurdle rates were common in the past, they have become a rarity, with only 14% of hedge funds including them in the performance fee calculation.
  • Last, a performance fee will be paid only if the fund’s net asset value exceeds its high-water mark, first set at the initial NAV, and adjusted to the level attained each time a performance fee is paid.

A Numerical Example

To illustrate performance fee calculations, let’s assume that all fee calculations are made at the end of the year. The other assumptions are outlined below.

  • NAV at inception: $10 million
  • Initial high-water mark: $10 million
  • Base fee: 1.5%
  • Performance fee: 19%
  • Hurdle rate: 3%
  • Year 1 gross return: 10%
  • NAV before fees at the end of year 1: $11 million

Calculations

  • Base fee: $11 million × 1.5% = $165,000
  • Hurdle rate: $10 million × 3% = $300,000
  • High-water-mark test: $11 million – $165,000 – $300,000 = $10,535,000

This amount surpasses the high-water mark of $10 million; thus, a performance fee is owed.

  • Value-added: $10,535,000 – $10,000,000 = $535,000
  • Performance fee: $535,000 × 19% = $101,650
  • NAV at the end, net of all fees: $11 million – $165,000 – $101,650 = $10,733,350
  • Net return to investors in Year 1 = ($10,733,350 ÷ $10 million) – 1 = 7.33%

Fee Issues

There are several problems and areas of uncertainty when calculating hedge fund fees.

First, as shown above, these calculations can be quite complicated. Investors must understand the fee structure of a hedge fund inside out before investing. Even a fund run by an outstanding manager may not deliver value-added if the fee structure is too harsh. Keep in mind: you can’t pay for groceries with pre-fee profits! A fee structure that appears acceptable on the surface may not be appropriate once you look at the details. For example, one-third of hedge funds do not have a high-water mark, so investors could be charged performance fees even when the fund loses money. The fees could be payable monthly or quarterly rather than annually, subtracting even more from investors’ returns.

Another problem with fee calculation occurs when hedge funds invest in private assets while retaining discretion over their valuation. This puts the manager in a conflict of interest: the higher the valuations, the higher the reported net asset value, which boosts returns and fees. In such cases, the manager is the judge and the party.

This problem can also occur when the fund invests only in public markets. Some researchers have found that hedge funds manipulate stock prices on critical reporting dates, although this finding was later challenged.

In real-life cases, hedge fund valuation is a genuine concern. For example, in 2017, PSP Investments settled a dispute with hedge fund manager Saba Capital Management after the latter allegedly depressed the valuation of illiquid bond holdings to defraud the Canadian pension manager. More recently, hedge fund manager Two Sigma was on the cusp of paying $100 million in fines after an employee manipulated asset valuations to enhance compensation.

Performance Fees Without Performance

There are many scenarios in which the investor can be charged performance fees while losing or making little money.

One scenario is a fund that performs well for some time, allowing the manager to pocket performance fees, but later loses money and never recovers from these losses. Even if the NAV of the fund subsequently falls below its inception value, the performance fees paid out are not recoverable.

As mentioned earlier, if a fund does not have a high-water-mark provision, investors may be charged performance fees after a positive return period, even if the fund is still underwater over its lifetime.

Another scenario occurs when an investor holds several hedge funds, with a combination of winning and losing funds. While the winning funds may legitimately charge performance fees, the losing funds reduce the total pool of profits generated by the hedge fund portfolio in aggregate. As a result, the investor could be paying a much higher rate than the contractual performance fees. A study surveying a pool of almost 6,000 hedge funds from 1995 to 2016 found that while the average performance fee of this pool was 19%, investors paid nearly 50% of the aggregate funds’ gross profit.

Conclusion

Hedge fund investing requires more investigation into fees than just looking at base and performance fee percentages. A high-water-mark provision, a substantial hurdle rate, and how and at what frequency the manager gets compensated will determine if the right incentives are in place to favour the fund’s performance.

Our next post will discuss the skill, performance, and persistence of hedge fund managers.

About The Author
Raymond Kerzérho
Raymond Kerzérho

Raymond contributes to PWL with his thirty years of experience in investment strategy and fixed income portfolio management.

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