Demystifying Hedge Fund Fees
Today hedge fund investors are focusing on negotiating the fees they pay to the managers. Wealth managers who are new to the world of hedge funds need to have a strong understanding of these fee structures to ensure they receive the best deal for their clients, with that in mind here’s a crash course on hedge fund fees and terminology.
A widely known fact about hedge funds is that they have considerable fees. Hedge funds, unlike mutual funds, receive their most lucrative fees from performance. Most hedge funds contain a 2 and 20 compensation structure. The 2 refers to the 2 percent standard fixed management fee charged to ensure the fund is able to perform its investment strategies. The 20 refers to the 20 percent performance fee received by the manager when a profit is generated. While the compensation structure is quite lucrative it is important to note that a manager only receives this fee if they produce a profit for investors. Unlike a mutual fund, you only pay when you make money. The 20 percent is not a standard charge paid by the underlying investors; rather it refers to a percentage of the gross profits generated on the fund level. When evaluating hedge funds, investors should consider if a fund uses a high-water mark. A high-water mark protects investors from paying a performance fee if they are experiencing a net loss. A high-water mark prevents a manager from receiving a performance fee if they generated a loss in one period. The manager can only begin receiving his performance fee once the loss for the investor has been recovered. The high-water mark limits the amount of risk taken by the fund. In a sense the manager only makes money when the investor makes money. Another option investors should consider is a hurdle rate. The hurdle rate is the minimum return the hedge fund manager must generate before a performance fee can be collected. The rate is often tied to London Interbank Offering Rate (LIBOR) and provides the investor with some cushion on their net returns. If a hurdle rate of 4 percent is applied to a fund and the manager generates a return of 14 percent, the performance fee can only be applied to the amount in excess of the hurdle rate, or 10 percent.
In addition to fees, investors should also be aware of the liquidity constraints that hedge funds present. Unlike a traditional investment in a mutual fund or an individual stock, most hedge funds do not provide the convenience of daily liquidity. Hedge funds impose liquidity constraints on investors for a variety of reasons. They traditionally enjoy large investment minimums, often resulting in a limited number of investors putting capital into the funds. As a result, the redemption request of a single investor can have a significant adverse impact on the remaining investors, to protect the stability of capital and discourage investors from irrational liquidations, hedge funds mandate liquidity periods and require notice. Most hedge funds provide investors with quarterly liquidity and require 45 days notice. This means that an investor can only redeem their shares at the end of a quarter and must notify the fund manager 45 days prior to the start of the quarter they intend to liquidate. This allows the manager to liquidate the positions in the portfolio at terms favorable for all investors. In addition, many hedge funds employ strategies fairly illiquid in nature that impose even stricter guidelines on liquidity, allowing for only annual or semi-annual redemptions; although, liquidity constraints are not limited to the this scenario. Many hedge funds also impose a Lock-Up period. The lock-up period is imposed when an investor first invests in a fund, and can last anywhere from six months to three years. When investors choose to invest in a fund they are notified of the lock-up period during which they are not permitted to redeem their shares. In an effort to be more investor friendly, many hedge funds use a soft lock-up period that allows investors to redeem their shares during the lock-up period for a set fee of 2 to 3 percent.
When considering a hedge fund investment investors should consider the illiquid nature of the fund and the consequences of that illiquidity. In extreme cases, funds have imposed gates on investor redemptions. Gates are imposed when a hedge fund experiences a significant spike in investor redemption requests. These gates provide them with a way to stem the requests by limiting the amount of the investment that can be redeemed which eases the liquidity pressures to the portfolio and ensures that the fund manager can sell its securities in an orderly fashion. Unfortunately gates are most often imposed when the markets are acting irrational or liquidity has become unavailable making it virtually impossible to redeem your shares. Investors may risk their entire investment should the worst-case scenario occur; therefore you should understand and carefully consider the liquidity of the fund’s underlying investments before investing in a hedge fund.
