Hedge Fund Fee Structures

Hedge Fund Fee Structures
3.1 Performance-based Fees
Hedge fund managers are compensated by two types of fees: a management fee, usually a percentage of the size of the fund (measured by AUM), and a performance-based incentive fee, similar to the 20% of profit that Alfred Winslow Jones collected on the very first hedge fund. Fung and Hsieh (1999) determine that the median management fee is between 1-2% of AUM and the median incentive fee is 15-20% of profits. Ackermann et al. (1999) cite similar median figures: a management fee of 1% of assets and an incentive fee of 20% (a so-called “1 and 20 fund”).
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. Liang (1999) reports that a 1% increase in incentive fee is coupled with an average 1.3% increase in monthly return. Ackermann et al. (1999) 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 [Tremont, 2002]. 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.

To ensure profits are determined fairly, high water marks and hurdle rates are sometimes included in the calculation of incentive fees. A high water mark is an absolute minimum level of performance over the life of an investment that must be reached before incentive fees are paid. A high water mark ensures that a fund manager does not receive incentive fees for gains that merely recover losses in previous time periods. A hurdle rate is another minimum level of performance (typically the return of a risk-free investment, such as a short-term government bond) that must be achieved before profits are determined. Unlike a high water mark, a hurdle rate is only for a single time period. Liang (1999) determined that funds with high water marks have significantly better performance (0.2% monthly) and are widespread (79% of funds). Hurdle rates are only used by 16% of funds and have a statistically insignificant effect on performance.