Hedge funds are expensive, for a variety of reasons. If a fund manager figures out a way to get an increased return for a given level of risk, he deserves to be paid for the value he creates.
One reason hedge funds have become so popular is that money managers want to keep the money that they earn instead of getting bonuses only after they meet big corporate overhead. Face it — a good trader would rather keep his gains than share them with an overpaid CEO who doesn’t know a teenie from a tick.
Almost all hedge fund managers receive two types of fees: management fees and performance fees. More than anything else, this business model, not the investment style, distinguishes hedge funds from other types of investments.
A management fee is a fee that the fund manager receives each year for running the money in the fund. Usually set at 1 percent to 2 percent of assets in a fund, the management fee covers certain operating expenses, salaries for the fund manager and staff, and other costs of doing business. The fund pays other expenses in addition to the management fee, such as trading commissions and interest.
For example, say a hedge fund has $100,000,000 in assets. It charges a 2-percent management fee, which is $2,000,000. The fund has an additional $1,750,000 in trading expenses and interest. The fund investors have to pay fees from the assets whether the fund makes money or bombs.
Most hedge funds take a percentage of the profits as a performance fee — also called the incentive fee or sometimes the carry. The industry standard is 20 percent, although some funds take a bigger cut and some take less. You need to read the offering documents you receive from a fund to find out what the fund charges and whether the fund’s potential performance justifies the fee.
If the fund loses money, the fund manager gets no performance fee. In most funds, the fund managers can’t collect performance fees after losing years until the funds’ assets return to their previous high levels, sometimes called the high-water marks.
