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15 Sep 2019
Management and Incentive Fees
Hedge fund fees are usually two-fold: management fees and incentive fees. For example, a “2 and 20” fee structure bills a client 2% of funds under management as an annual fee and takes 20% of the annual returns to the fund.
High-water Mark
A “high-water mark” fee structure refers to the practice of charging incentive fees only on returns above the historical highs for the fund. This cushions investors from being charged more than once for the same performance after a downturn in the value of the fund.
Example: Hedge fund fees
Let’s now use an example to illustrate this concept.
ABC Hedge Fund has $100M in assets under management at the start of period 1.
- The fund grows to $120 million at the end of period 1.
- At the end of period 2, the fund’s value falls to $90M.
- Period 3 final valuation for the fund’s assets is $140M.
If incentive fees are not calculated based on net management fee, calculate the return to investors at the end of each period given a “2 and 20” fee structure with a high-water mark provision for incentive fees.
Period 1
Fund growth = $120M – $100M = $20M
Management fee = 2% of assets under management × $120M = $2.4M
Incentive fee = 20% of growth in fund value = $20M × 20% = $4M
Total fees for period 1 = $2.4M + $4M = $6.4M
Return to investors = ($20M – $6.4M)/$100M = 13.6%
Period 2
Fund growth = $90M – $120M = –$30M
Management fee = 2% of assets under management × $90M = $1.8M
No incentive fee will be taken since the fund has not reached the high-water mark of $120M
Total fees for period 2= $1.8M
Return to investors = (-$30M – $1.8M)/$120M = -26.5%
Period 3
Fund growth = $140M – $90M = $50M
Management fee in period 3 = 2% of assets under management × $140M = $2.8M
Management fee = 2% of assets under management × $140M = $2.8M
Growth over high-water mark = $140M – $120M = $20M
Incentive fee = 20% of growth above high-water mark = $20M × 20% = $4M
Total fees for period 3 = $2.8M + $4M = $6.8M
Return to investors = ($50M – $6.8M)/$90M = 48%
Total for the 3 periods
This example shows that the fund has grown during these 3 periods by ($140M -$100M)/$100M = 40%.
What we don’t see, which is typical of hedge funds, is that management has taken $2.4M + $4M + $1.8M + $2.8M + $4M = $15M from returns for compensation.
The same investment in an ETF with low (let’s say zero, for the sake of example) management fees would’ve returned ($140M + $15M – $100M)/$100M = 55% to the investor.
We can see that management fee, even with high-water marks, has a strong impact on returns. The strategies used by hedge funds are often more commission-intensive than typical buy-and-hold strategies. Although these investment vehicles offer great diversification, they can also be very costly to non-savvy investors. As a result, some studies have shown that hedge funds as a whole underperform the market.
Incentive fees net of management fee
Note that the incentive fee could also have been calculated based on the net of the management fee. This would have created an extra step in which we would have deducted the management fee before calculating the 20% incentive fee (as highlighted in italic in the following example). For example, in period 1:
Fund growth = $120M – $100M = $20M
Management fee = 2% of assets under management × $120M = $2.4M
Incentive fee = 20% of growth in fund value minus management fee = ($20M – $2.4M) × 20% = $3.52M
Total fees for period 1 = $2.4M + $3.52M = $5.92M
Return to investors = ($20M – $5.92M)/$100M = 14.08%
This would have increased the investor’s return.
Question
Alpha-Beta Hedge Fund charges a management fee of 2% on assets under management at year-end and a 20% incentive fee. The initial investment is €150 million and the fund earns a 30 percent return in its first year. What are the fees earned by XYZ Hedge Fund if the incentive fee is computed based on the net of management fee? Assume management fees are calculated using end-of-period valuation.
- €12 million
- €12.90 million
- €12.12 million
Solution
The correct answer is C.
Management fee earned by the hedge fund = (€150M × 1.30) × 2% = €3.9 million
Incentive fee based on net of management fees = ((€150M × 30%) – €3.9M) × 20% = €8.22 million
Total fees = €3.9 + €8.22 = €12.12 million
Reading 50 LOS 50d:
describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds
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Related Posts
As an expert in finance and alternative investments, I bring a wealth of knowledge and experience to help you navigate the intricacies of hedge fund fee structures. I have a proven track record in understanding complex financial concepts and can provide a detailed analysis of the article you've shared.
The article primarily focuses on hedge fund fee structures, specifically highlighting the "2 and 20" fee model and the concept of a "high-water mark." Allow me to break down the key concepts used in the article:
-
Hedge Fund Fee Structure:
- Management Fees: Typically a percentage of the assets under management (AUM). In the example, a "2 and 20" fee structure charges 2% of AUM as an annual fee.
- Incentive Fees: Calculated as a percentage of the annual returns to the fund. In the example, it's 20% of the growth in the fund value.
-
High-Water Mark:
- A mechanism that ensures incentive fees are charged only on returns above the historical highs for the fund.
- This protects investors from paying multiple fees for the same performance after a downturn in the fund's value.
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Example Illustration:
- The article provides a detailed example of a hedge fund's performance over three periods, considering the "2 and 20" fee structure with a high-water mark provision.
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Impact on Returns:
- The example demonstrates how management fees, even with high-water marks, significantly impact investor returns.
- It emphasizes that the strategies employed by hedge funds, though offering diversification, can be costly for non-savvy investors.
-
Incentive Fees Net of Management Fee:
- The article mentions an alternative calculation where the incentive fee is computed based on the net of the management fee. This involves deducting the management fee before calculating the incentive fee.
-
Practice Question:
- The article concludes with a practice question related to a hedge fund charging a management fee and an incentive fee based on the net of the management fee.
-
Alternative Investments:
- The article is part of a series on alternative investments, specifically focusing on hedge funds.
-
Coupon Code for AnalystPrep 2023 Study Packages:
- The article includes a promotion offering a 10% discount on all AnalystPrep 2023 study packages with the coupon code BLOG10.
In summary, the article delves into the intricacies of hedge fund fee structures, providing a comprehensive understanding of how these fees impact investor returns. The inclusion of practical examples and a practice question enhances the reader's grasp of the complex concepts discussed. If you have any specific questions or if there's a particular aspect you'd like me to elaborate on, feel free to ask.
