Hedge Fund Fees Structure

Hedging is the alternative investment to reduce the risk of price change which has an adverse impact on the main portfolio. These investments will be net off when the main investment gets hit by the price drop. The hedge fund is a pool of investments invested by many investors and they are diversified into many different industries.  It is usually managed by the hedge fund manager who forms as a corporation. In short, it is another company led by the hedge fund manager who acts as a limited partnership.

Hedge fund managers invest in various security and equity and other assets to ensure the pool’s goals are met. The fund manager will charge a specific fee from the clients when based on the investment performance. The fees are separated into management fees and performance fees. The management fee is a percentage of assets under management control, it is ranged from 1% to 4%, mostly 2% per annum. It is paid by month or quarterly to cover the operating cost of the fund manager.

The performance fee is the percentage that the fund manager charges based on the profit made during the year. It is the most important revenue for the hedge fund firm, as it will link directly between their performance and reward. When they can increase clients as well as their revenue at the same time. In the next section, we will discuss only the performance fee and the factors impact.

What do Fund Manager Do?

The fund manager will raise funds from other investors and invest them into various categories base on his strategy in order to generate profit at a certain level. For example, he may use the fund to invest in the following:

  • Common Stock
  • Preferred Stock
  • Company or government’s bond
  • Real Estate
  • Startup
  • Investing in patent or copyright

High-water mark or Loss Carry Forward

These criteria allow the firm to charge performance fees only when the new profit-making on investment. It means that if there is a loss in the prior year, the profit needs to cover those losses before calculating the performance fee.  This rule ensures that the fund manager is not making money by taking advantage of investor’s loss. It is trying to balance both parties profits. It is so unfair when the firm keeps making a loss on client investment for a few years and charges the performance fee on the first profit while the client not yet even breakeven.

Hurdle Rate

In order to get confidence from investors, some firms even set the hurdle rate on the investment portfolio. It means that the firm will only charge performance fees when the return on investment is greater than the hurdle rate. So hurdle rate is the minimum rate which they need to make before getting a reward (fee). This rate is very subjective and different from one firm to another. Setting it too low will not attract the investor’s attention. Setting too high will become huge pressure for the fund manager to generate profit. It is usually around 2% per year.

Hedge Fund Crystallization Frequency

It is the frequency of fees is calculated and paid to the hedge fund firm. Most the firm will calculate the High-water mark once per year it will followed by the calculation of the performance fee. However, some other firms may charge more or less frequently than one time per year. The higher crystallization frequency means that the investors pay a higher fee.

2 and 20 (Hedge Fund Fees)

2 and 20 is the hedge fund fees structure that fund managers charge both the management fee and performing fee. The investors agree to provide 2% of the total assets under the portfolio to the management. In addition, they will provide 20% of the profit as well.

It will help the fund manager to charge the minimum fee as the income. It represents the revenue for the work that they manage the assets. These fees will help to generate revenue when the market is in a downturn. The loss is not the manager’s mistake, it is just the market performance.

This fee also aligns the interest between fund manager and the investors by providing 20% of the profit generated. It persuades the manager to work for the best interest of the investors. When the investors have more profit, managers also receive more profit as well. The 20% fee is calculated when the profit reaches a certain level. It will be the marketing for the fund managers to promise a high level of profit. The investors can take benefit by only paying the fee when a certain threshold is met.