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Hedge Fund Fees

Hedge Funds

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Hedge funds are expensive operations. The expenditures incurred range from typical business outlays (Office costs, Utilities, Salaries) and fund specific costs like research and consulting fees. Hedge Fund Fees are paid from investor deposits and returns earned by trading.

Investors desire to see substantial returns, and general partners controlling the fund desire to see personal profits. The returns earned by the fund must be high enough to keep both parties happy. Investors will leave the fund if they are not receiving adequate returns after fees, charges, and costs. If the general partners are not increasing their personal wealth through fees applied, they will eventually shut down the firm and begin elsewhere.

Initial Deposit Hedge Fund Fees

Hedge fund fees begin with a charge levied on the initial deposit. This fee ensures that applicants are serious about investing in the fund. This fee ranges from one to three percent of the money invested. This is directly comparable to a mutual fund’s front end load fee. Note that the charge is deducted from the money deposited, and is not an additional charge.

Hedge Fund Annual Charges

Fees for managing the funds after initial investment are also applied. These costs are charged annually against the fund’s invested asset base. They are one to two percent on the lower end. The high end is between six and seven percent. These fees will always be charged. On a personal level, the amount paid scales with the amount invested. For the fund, the dollar amount charged scales with the size of the asset base.

Performance Hedge Fund Fees

Hedge funds will additionally charge fees that are correlated with fund returns. These are known as hedge fund performance fees. They charge a percentage of all returns over a certain value, as defined by the fund’s prospectus. They commonly are 20% of value but may range up to 50% of annual returns. Some funds stagger these charges, as an example, charging 20% of returns at 10% annual return and charging 40% at 25% annual return.

Performance costs are more desirable than percentage of asset management fees. Management costs are charged even if losses are incurred, performance costs are only charged if returns are earned. Performance based prices generate an incentive to create returns. If losses occur, they may be restricted or eliminated until fund returns exceed losses sustained, which is known as a “watermark”. If this restriction can occur, it will be written into the fund’s prospectus or fee schedule.

This restriction on performance charges can backfire. If the losses are so dramatic that it is unlikely the fund manager will ever clear the watermark, general partners may completely disband the fund rather than skip their paychecks for years. Certain hedge funds reduce performance fees rather than eliminate them completely, providing some incentive to keep the fund open. Watermarks can create another issue. Managers may act recklessly to exceed the watermark, creating heavier losses when markets move against them.

Hedge Fund Risk Inequality

You may have noticed an ongoing problem with the fee structure. Fund managers share a potentially huge slice of gains made by the fund, but pay for little if any of the losses. Some hedge funds half-heartedly attempt to solve this issue by having managers invest personal wealth within the fund. Investors hope this will dissuade failure and encourage wise investment. You should never invest in a hedge fund where the manager has high performance costs and no money invested. If they don’t trust their own skill, neither should you.

Withdrawal Hedge Fund Fees

This unfortunately isn’t the end of the fees charged directly to investors by hedge funds. Hedge funds may also charge investors an exit or withdrawal fee. This fee is typically one to two percent of assets being removed from the fund. This is directly comparable to a mutual fund’s back end load. Withdrawal fees are often waived if investors have participated in the fund a specific amount of time. This dissuades investors from entering a fund, changing their minds, and withdrawing their money after managers have invested their capital. This prevents the disruption of trade by finicky investors. Withdrawal fees which do not decrease or disappear after specific timeframes will always cost investors part of their positions within a fund.

Hidden Fees

The fees listed above are only the explicit fees that investors are paying. There are two categories of fees all hedge fund investors silently pay: trading and consultation fees. Trading fees are the costs of brokers executing orders on behalf of the hedge fund. Due to volume, hedge funds can negotiate fees which may be substantially lower than what you would pay as an individual investor. These fees still exist. Most importantly, they are charged against the asset base and investor returns. Consultation fees are the cost of hiring outside parties to advise the fund. These parties can be legal, regional, geographic, economic, corporate, industrial, or political. Consulting fees are also charged against the asset base or investment returns.

Fee and Price Concerns

Performance in even the strongest of markets may be strongly reduced after fees. The differences are substantial: A hedge fund with equal return as the market will lose by its performance fee after costs are deducted. If a hedge fund and the market both have a 10% return, the hedge fund’s return is reduced to 8% by a 20% performance fee. The hedge fund will have to reach 12.5% to equal the market, and higher returns to beat the market with a 20% performance fee. This is before including trading commissions, consultation fees, and asset under management fees. Returns will need to perform even higher to beat the market with these fees included. During the year you are exiting the fund, you will pay withdrawal fees, and these returns will have to be even higher to beat the market.

In bad scenarios fees may be reduced substantially below the market returns. In nightmare scenarios the expenses will create losses. If you’re unsure if hedge fund managers in a specific sector can beat the market by more than their fees, look at cheaper alternatives targeting the same area: index, exchange traded, and mutual funds. In order to justify a hedge fund investment, return must be substantially higher than your accessible alternatives or the fund must offer exposure to different risk return profiles. If you can invest in the same basket of assets cheaper via an index, exchange traded, or mutual funds, there are few reasons to pay substantially more for similar asset coverage.

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