Performance-based Fees

The cost structure of a hedge fund is usually complex. It consists of various payments and is usually higher compared to traditional funds. Investors have to pay start-up costs, management costs and sometimes exit costs. Apart from that, total costs also depend on performance. These fees give incentives to the management to take greater risks (hurdle rates) and profits from any upside but not necessarily carry only limited risk if losses occur (watermarks).

The typical hedge fund manager charges a management fee in excess of 1% (versus 40-50 basis points on the typical long only portfolio) and usually is entitled to 20% of the profit if a certain target return is exceeded.

Hedge fund managers are compensated by two types of fees.

• Management fee: This is usually a percentage of the size of the fund (AUM), and a performance-based incentive fee. , similar to the 20% of profit that Alfred Winslow Jones collected on the very first hedge fund. The median management fee is between 1-2% of AUM and the median incentive fee is 15-20% of profits.
• Incentive Fee: Most hedge funds charge an incentive (or performance) fee of anywhere between 10-20% of fund profits. The idea of the incentive fee is to reward the fund manager for good performance. Managers only collect an incentive fee when the fund is profitable, exceeding the fund’s previous high – called a high-water mark. This means that if a fund loses 5% from its previous high, the manager will not collect an incentive fee until he or she has first made up the 5% loss. The incentive fee is a crucial feature for the success of hedge funds. A pay-for-profits compensation causes the manager’s aim to be absolute returns, not merely beating a benchmark. To achieve absolute returns regularly, the hedge fund manager must pursue investment strategies that generate returns regardless of market conditions; that is, strategies with low correlation to the market. However, a hedge fund incentive fee is asymmetric; it rewards positive absolute returns without a corresponding penalty for negative returns.

Empirical studies provide evidence for the effectiveness of incentive fees. Reports show that a 1% increase in incentive fee is coupled with an average 1.3% increase in monthly return. Specialists determine that the presence of a 20% incentive fee results in an average 66% increase in the Sharpe ratio, as opposed to having no incentive fee. The performance fee enables a hedge fund manager to earn the same money as running a mutual fund 10 times larger. There is the possibility that managers will be tempted to take excessive risk, in pursuit of (asymmetric) incentive fees. This is one reason why, in many jurisdictions, asymmetric incentive fees are not permitted for consumer-regulated investment products.

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