Unraveling Hedge Fund Benefits and Fees | CFA Level I Alternative Investments
In this lesson, we will explore the diversification benefits of hedge funds and their fee structure.
Diversification Benefits of Hedge Funds
As we learned in the last lesson, the hedge fund universe is vast and varied in strategies, instruments, and geography. Thus, generalizations about hedge fund performance and diversification benefits can be misleading. However, some observations can be made:
- Hedge funds tend to perform better than global equities in down markets and lag in up markets.
- They have less-than-perfect correlation with global equity returns, offering potential diversification benefits.
- Correlations may increase during financial crises.
Hedge Fund Fees: The Pricey Side of the Coin
While opinions on hedge fund returns and diversification benefits may vary, one thing is certain: hedge fund fees are high. The common fee structure is “2 and 20,” representing a 2% management fee and a 20% incentive fee. Additionally, funds of hedge funds typically charge a “1 and 10” fee on top of the individual hedge fund fees.
Management Fees
Management fees can be calculated on either the beginning-of-period or end-of-period values of assets under management.
Incentive Fees
Incentive fees are calculated based on profits for the specified period. Profits can be:
- Any gains in value,
- Gains in value in excess of the management fee, or
- Gains in excess of a hurdle rate.
A hurdle rate can be set as an absolute percentage or a rate relative to a Market Reference rate (MRR). Hurdle rates can be hard or soft:
- Hard hurdle rate: Incentive fees are earned only on returns in excess of the hurdle.
- Soft hurdle rate: Incentive fees are paid on all profits, but only if the hurdle rate is met.
EXAMPLE
A “2 and 20” fee structure with a hard hurdle rate of 8% vs. a soft hurdle rate of 8%:
If the return is 3%, neither manager will receive an incentive fee because the 8% hurdle rate is not met. However, if the return is 15%, the incentive fee for a hard hurdle rate is 20% of 7% (1.4%), and for a soft hurdle rate, it is 20% of 15% (3%).
Some implementations of a hard hurdle include a “catch-up” clause, allowing the incentive fee under a hard hurdle rate to catch up to the fee under a soft hurdle.
High Water Mark
A high water mark ensures that investors aren’t charged incentive fees twice on the same gains in their portfolio values. Clients are not charged an incentive fee if the latest cumulative return does not exceed the prior high water mark.
EXAMPLE
A hedge fund starts at $100 in portfolio value:
- In the first year, the portfolio increases to $130 after fees. The incentive fee will apply, and the new high water mark is set at $130.
- In the second year, the portfolio ends at $125. No incentive fee will apply because the value is below the high water mark.
- In the third year, the portfolio rises to $143. The incentive fee will apply only to the increase above the high water mark, which is now $130. The high water mark will be set at $143 from this point onwards.
Negotiating Hedge Fund Fee Structures
Although “2 and 20” and “1 and 10” were once standard fee structures, they are now under competitive pressure and considered negotiable. Fees can be negotiated based on investment size, liquidity provisions, and hurdle rates. Early participation in start-up and emerging hedge funds can be incentivized with founders’ class shares, offering a lower fee structure.
Regardless of the negotiated fee structure, the terms should be detailed in side letters to the Limited Partnership Agreement (LPA), specifying how their terms differ from those in the standard offering documents.
Components of Hedge Fund Returns
Hedge fund returns can be dissected into three main components, each contributing to the overall performance in unique ways:
- Market Beta: This represents the portion of returns that correlates with the general market’s movements. Passive investments like index funds are a common way for investors to gain exposure to market beta.
- Strategy Beta: Reflects returns from specific market sectors targeted by the hedge fund. This strategic placement can significantly influence fund performance.
- Alpha: The value added by the hedge fund manager’s skill in selecting securities. It represents the extra return beyond what could be expected from market and strategy beta alone.
Leverage and Its Impact
Leverage is a tool often used by hedge funds to magnify returns from both strategy beta and alpha. However, it’s important to note that:
- Leverage can increase the potential for higher returns but also amplifies risk.
- The benefits of leverage can be offset by the high fees charged by hedge funds, potentially reducing net returns to investors.
Challenges in Evaluating Hedge Fund Performance
Assessing the performance of hedge funds involves navigating several biases:
- Self-reporting Bias: Performance indexes may be skewed as they rely on voluntary data submissions from fund managers, potentially excluding underperforming funds.
- Survivorship Bias: Performance measures might only reflect surviving funds, ignoring those that have ceased operations.
- Backfill Bias: Funds may selectively report favorable past performance data, leading to an overly positive historical performance record.
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