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Set out the strategies hedge funds use and how they charge fees

CFA® Level I · Alternative Investments · Hedge Funds · AI.3.a

The idea

Hedge funds are defined less by what they invest in than by how they are allowed to operate: leverage, short selling and derivatives are available to them, and their investors accept lock-ups and limited transparency in exchange. Strategies group into equity hedge, event driven, relative value and macro in one common classification, and they have little in common beyond the freedom. Fees are the part that decides outcomes: a management fee on assets plus an incentive fee on profits, classically two and twenty. A high-water mark stops the same gains being charged for twice after a loss, and a hurdle rate withholds the incentive fee until a threshold return is cleared. Reported index returns flatter the industry, because funds that fail stop reporting.

A practice question

From the question bank, with the reason each wrong option is wrong.

A classic hedge fund fee arrangement of 'two and twenty' means:

  1. a 2% management fee and a 20% incentive fee — correct
  2. a 2% incentive fee and a 20% management feeWhy not: Reverses the two. A 20% annual charge on assets would consume the portfolio regardless of performance.
  3. 2% of profits and 20% of assetsWhy not: Attaches each percentage to the wrong base as well as reversing them.

One fee is charged on assets whatever happens, the other only on gains, and the two behave very differently.

A harder one

A fund charges 2% of assets and 20% of profits above a high-water mark. Starting at $100 and ending at $120 before fees, total fees are closest to:

  1. $2.0Why not: The management fee alone, omitting the 20% share of the $20 gain.
  2. $4.0Why not: The incentive fee alone, omitting the 2% charged on assets.
  3. $6.0 — correct

Two per cent of assets is about 2, and twenty per cent of the 20 gain is 4, giving roughly 6 in all.

The hardest tier

An incentive fee without a high-water mark is most costly to an investor in a fund whose returns are:

  1. steadily positiveWhy not: Every gain is new and would be charged under either arrangement, so the mark makes no difference.
  2. steadily negativeWhy not: No incentive fee arises on losses either way.
  3. volatile, with large losses and recoveries — correct

Each recovery is billed as fresh profit, so the investor pays repeatedly for regaining the same ground.

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