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Work out hedge fund fees and explain what they mean

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

The idea

The standard structure charges a management fee on assets and an incentive fee on profits. A hurdle rate means the incentive fee applies only to returns above a stated threshold, and it may be hard — charged only on the excess — or soft, charged on the whole return once the hurdle is cleared. A high-water mark prevents the manager from charging twice for recovering the same losses: no incentive fee is due until the fund exceeds its previous peak value. The order in which management and incentive fees are applied changes the answer and must be read from the terms.

Formulas

Hedge fund fees

total fee = (management rate × assets) + (incentive rate × excess profit)

management rate
the annual percentage charged on assets, whatever the fund returns
assets
the value the management fee is struck on — beginning or ending, which the offering document decides
incentive rate
the share of profit the manager keeps, commonly a fifth
excess profit
profit above the hurdle rate, and above the high water mark where one applies

Read the two details, because they change the number: whether the incentive fee is charged on profit net of the management fee, and whether a high water mark means past losses must be recovered before the manager is paid again.

A practice question

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

What does a high-water mark prevent?

  1. The manager from charging any fee in a loss yearWhy not: The management fee continues to accrue on assets whatever happens.
  2. The fund from using leverage above a stated levelWhy not: Leverage limits are set in the fund's terms and are unrelated to the fee mechanism.
  3. The manager from earning an incentive fee twice on the same gains after a loss — correct

Without it, a fund that fell and recovered would pay performance fees on the recovery even though the investor is no better off than before.

A harder one

A fund charges 2% of assets and 20% of returns above a 5% hard hurdle. Beginning value is 100 and it earns 15% gross. What is the total fee?

  1. 4.00 — correct
  2. 5.00Why not: The soft-hurdle answer, charging 20% on the whole 15%. A hard hurdle charges only on the 10% above it.
  3. 3.00Why not: The incentive fee computed on the entire return, with the 2% management fee omitted.

The management fee is 2. The hard hurdle means the incentive fee applies to 15% - 5% = 10, so 20% of 10 is 2. Total 4.

The hardest tier

Why does a soft hurdle produce a higher fee than a hard hurdle at the same return?

  1. Because a soft hurdle carries a higher management feeWhy not: The management fee is set separately and does not change with the hurdle type.
  2. Because the fee is then charged on the whole return — correct
  3. Because a soft hurdle ignores the high-water markWhy not: The two provisions operate independently; a soft hurdle fund can and usually does have a mark.

Once a soft hurdle is cleared the incentive fee applies to the entire return rather than the excess over it. The hurdle acts as a gate rather than a deduction: in the example above a soft hurdle would charge 20% of the full 15, or 3, instead of 2.

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