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Hedge Fund Management Fee/Performance Fee Structure Explained

September 13, 2011

Hedge funds typically charge a 2/20 fee structure, i.e., a 2% management fee and 20% performance/incentive fee. The management fee is a flat fee structure which is a percentage of assets under management (AUM) that may be charged on a monthly, quarterly, semiannual or annual basis. It is not performance based, which means regardless on how the hedge fund performs, the manager still collects the management fee. However, if the hedge fund doesn’t perform to investors’ expectations/mandates, then it may experience redemption from investors, absent a lock-up period, as hedge funds doen't have permanent capital. Thus, in the long run, a poorly performing hedge fund may wind up its business due to lowered AUM, which cripples its ability to invest profitably or lack of investors’ confidence.

The performance fee is a profit-sharing fee which is computed as a percentage of a hedge fund’s profit, typically collected on an annual basis. Hedge fund incentive fees may be akin to a free call option as they have asymmetric rewards (that is, the hedge fund manager shares a portion of upside profits but not on the downside).

However, a high watermark provision may deter the hedge fund manager from taking unwarranted risk in order to churn out profits. The incentive fee can only be doled out to the hedge fund manager provided he outperform the high watermark, which is the highest previous net asset value of the fund.

There are, however, two manners in which the fee structure may impact monthly returns:

1) Hedge funds' tailored/bespoke investments are negotiated at different times and among different investors. Thus the terms of investment contract may vary according to the market milieu. Therefore investors are not expected to earn the same net of fees returns.

2) Indices provide monthly performance, but incentive fees are computed on an annual basis. Ergo, incentive fees need to be estimated each month and subtracted from performance, which explains the discord between estimated monthly fees and actual year end incentive fees.

The article explains the importance of management fees to hedge funds: UPDATE 1-Fund manager Charlemagne sees lower H2 management fees

About the author:

Graduated with BA Economics from National University of Singapore. Passed Level 1 of the CFA examination and CAIA Level I Candidate. Long-biased US equities, with strong focus on small to mid-cap stocks (NYSE, NASDAQ, AMEX, OTC & ADR) utilizing fundamental and technical analysis.

Agnostic investor, trader, writer and perpetual student of the market.

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