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Hedge funds typically charge two levels of fees. There is a management fee which typically ranges from 1.5% to 2.0% although there are funds that charge less, from 0.5% to 1.0%, and funds that charge as much as 5.0%. The fees are charged on the size of the capital invested, that is on the equity contribution of the investor or the gross asset value (GAV) of the shares owned by the investor.

There is also almost always a performance fee being a percentage of profits. The structuring of the management fee can vary, as can the proportion. Typically, hedge funds charge between 10% - 25% of gross returns in performance fees.

Sometimes the performance fees are levied only after a performance target has been met. This is called the Hurdle or Hurdle Rate. Typical hurdle rates are a fixed 5% - 8% or a variable rate linked to short term interest rates for example 3 month USD LIBOR. This practice has diminished as demand for hedge funds has outstripped supply. The typical hurdle is currently 0% i.e no hurdle.

Performance fees have been accused of introducing perverse behavior on the part of hedge fund managers in that they are not penalized for negative or poor performance. The High Watermark mechanism in part addresses this problem. Under a high watermark system, performance fees only apply to net new profits for each individual investor. That is, if a fund has risen say 30% and performance fees are 20% of returns, then performance fees are 20% of 30% which is 6%. If the fund then drops 10%, no performance fees are due to the hedge fund manager. Further, until the 10% loss is fully recovered, no performance fees will accrue to the hedge fund manager. Only when the loss is fully recovered, hence the concept of high watermark, will performance fees apply and then only to the performance calculated from the high watermark.

Performance-based management fees have been criticised by people including investor Warren Buffett for rewarding managers for high variability, rather than high long-term returns. A fund that may gain $100M in one year and lose $100M in the next year may pay its managers a performance fee of $30M or more for the profitable year, although the nominal return is zero, and the real return after fees is negative.

An illustration::

The typical hedge fund charges what is known in the industry as 2 and 20 by which is meant that management fees are 2% per annum and performance fees are 20% of whatever returns are generated. All these fees apply to gross asset values and gross performance.

Assume that a hedge fund returns 15% in a year net of all fees. This means that the gross returns must add back the 2% management fee and adjust for the 20% share of gross returns that accrue to the hedge fund manager.

Gross returns are therefore (15% + 2%) / (100% - 20%) = 21.25%.
Total fees to the hedge fund manager are therefore 21.25% - 15.00% = 6.25%
Net returns to the investor = 15%

Thus of the gross returns generated by the hedge fund manager, some 30% of the returns are retained as fees and 70% paid to the investor. While the precise quanta of fee shares will depend on the precise fee terms of each fund and the level of gross returns generated, the numbers above are within the realm of contemplation.

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