A hedge fund manager will typically receive both a management fee and as well as performance fee (also known as an incentive fee) from the fund. A distinctive manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% out of the fund's profit.
As with other investment funds, the management fee is also calculated as a percentage of the fund’s net asset value. Management fees classically range from 1% to 4% per annum, with 2% being the standard figure. Management fees are regularly expressed as an annual percentage but calculated and paid monthly or quarterly.
The business models of most of the hedge fund managers provide for the management fee to cover the operating costs of the manager, but leaving the performance fee for employee bonuses. Though, in large funds the management fees may form a significant part of the manager's profit.
Performance fees (or "incentive fees") are one of the defining uniqueness of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, generally counting both realized and unrealized profits. By incentivizing the manager to produce returns, performance fees are anticipated to align the interests of manager and investor more closely than flat fees do. In the business models of most managers, the performance fee is principally available for staff bonuses and so can be enormously lucrative for managers who perform well. Several publications publish annual estimates of the earnings of top hedge fund managers.
Characteristically, hedge funds charge 20% of returns as a performance fee. Nevertheless, the range is spacious with highly regarded managers charging higher fees. For instance Steven Cohen's SAC Capital Partners charges a 35-50% performance fee, whereas Jim Simons' Medallion Fund charged a 45% performance fee.
Performance fees have been criticized by most of the people, including notable investor Warren Buffett, who believe that, by allowing managers to take a share of profit but providing no instrument for them to share losses, performance fees give managers an incentive to take extreme risk rather than targeting high long-term returns. In an endeavor to control this problem, fees are usually limited by a high water mark.
As the hedge fund compensation structure is highly attractive it has been made fun that hedge funds are best viewed "... not as a unique asset class but as a unique ‘fee structure’".
A high water mark (or "loss carry forward provision") is frequently applied to a performance fee calculation. This means to say that the manager only receives performance fees on increases in the net asset value of the fund in overindulgence of the highest net asset value it has previously achieved. For instance, if a fund were launched at a net asset value per share of $100, which then increased up to $120 in its first year, a performance fee would be payable on the $20 return for each share. If the next year it dropped for about $110, no fee is payable. If in the third year the NAV per share once again increases to $130, a performance fee will be payable only on the $10 return from $120 (the high water mark) to $130 rather than on the full return during that year from $110 to $130.
This measure is anticipated to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek impulsive trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would produce a performance fee every other year, enriching the manager but not the investors.
The mechanism does not provide absolute protection to investors: a manager who has lost a significant percentage of the fund's value may close the fund and begin again with a clean schedule, rather than continue working for no performance fee until the loss has been made good. This approach is dependent on the manager's ability to persuade investors to trust him or her with their money in the new fund.
Some managers specify a hurdle rate, suggesting that they will not charge a performance fee until the fund's annualized performance exceeds a target rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to provide a higher return than a substitute, usually lower risk, investment.
With a "soft" hurdle, a performance fee is charged on the whole annualized return if the hurdle rate is cleared. With a "hard" hurdle, a performance fee is only charged on returns greater than the hurdle rate. Proceeding to the credit crisis of 2008, demand for hedge funds tended to outstrip supply, making hurdle rates relatively rare.
Some funds charge investors a redemption fee (or "withdrawal fee" or "surrender charge") if they pull out money from the fund. Where a redemption fee exists, it is often charged only during a certain period of time (typically one year) subsequent the investment, or to withdrawals representing a particular portion of an investment.
The purpose of the fee is to dampen short-term investment in the fund, in that way reducing turnover and allowing the use of more complex, illiquid or long-term strategies. The fee may also discourage investors from withdrawing funds after periods of poor performance.
Unlike management and performance fees, redemption fees are regularly retained by the fund and as a result directly benefit the remaining investors rather than the manager.
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