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What is a Hedge Fund?

A hedge fund, an alternative investment vehicle, is a partnership where investors

(accredited investors or institutional investors) pool money together, and a fund manager
deploys the money in a variety of assets using sophisticated investment techniques. Hedge
funds, as opposed to other funds, can use leverage, take short positions, and hold
long/short positions in derivatives. Hedge funds are less strictly regulated by the Securities
and Exchange Commission (SEC) as opposed to other funds.

Quick Summary:

 A hedge fund, an alternative investment vehicle, is a fund that pools

investors’ money together and utilizes sophisticated investment strategies
to generate returns.
 Hedge funds are only accessible to accredited and/or institutional
investors.
 The four main classifications of hedge fund strategies are event-driven,
relative value, macro, and equity hedge.

Defining Accredited and Institutional Investors

Hedge funds are only accessible to accredited and/or institutional investors.

An accredited investor is an individual or business entity that is allowed to invest in

securities that may not be registered with the financial authorities. In the United States, one
must have a net worth of at least $1,000,000 (excluding the value of the primary residence)
or an annual income of at least $200,000 for the past two years. Rule 501 of Regulation D
of the U.S. Securities and Exchange Commission goes into further detail in defining
“accredited investors.”

An institutional investor is a non-bank individual or company that trades securities on behalf

of its members in large dollar or quantity amounts. Institutional investors include pension
funds, mutual fund companies, insurance companies, commercial banks, mutual funds, or
hedge funds. Due to the deep pockets of institutional investors, they play a major role in the
securities market.

Common Hedge Fund Strategies

Hedge Fund Research, Inc. identifies four main classifications of hedge fund strategies. Each
strategy entails different risk and reward profiles:

1. Event-driven strategies

Strategies that seek to gain from inefficient price changes due to specific corporate events,
corporate restructurings, mergers and takeovers, asset sales, spin-offs, bankruptcies, and
other events.
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2. Relative value (arbitrage) strategies

Strategies that seek to gain from price discrepancies between related securities whose price
discrepancy is expected to be resolved over time.

3. Macro strategies

Strategies that seek to gain from global economic events and trends such as interest rate
changes, currency changes, political changes, and others, by acquiring holdings with positive
or negative exposure to such macro events. Macro strategies revolve around the prediction
and projection of macro events.

4. Equity hedge strategies

Strategies that seek to gain from long and/or short positions in equities and derivatives.

Hedge Fund Fee Structure

A common hedge fund fee structure is called “2 and 20”. It means that the fund manager
will charge a 2% management fee applied to the assets under management and a 20%
incentive fee on returns greater than a specified hurdle rate. Incentive fees are only
collected when the portfolio generates a higher return than the hurdle rate. Hurdle rates can
be “hard” or “soft”:

1. Hard

A hard hurdle rate means that incentive fees are only collected on returns in excess of the
benchmark. For example, if a hedge fund returned 25% with a 10% hurdle rate, incentive
fees would be collected on the excess return of 15%.

2. Soft

A soft hurdle rate means that incentive fees are collected on the entire return of the
portfolio so long that the return is greater than the hurdle rate. For example, if a hedge fund
returned 25% with a 10% soft hurdle rate, incentive fees would be collected on the total
portfolio return of 25%.

Example of a Hedge Fund Fee Structure

ABC Fund is a hedge fund with $100 million assets under management. The fund follows a
“2 and 20” fee structure with a hard hurdle rate of 15%. Incentive fees are calculated on
gross gains and not gains net of management fees. The performance of the hedge fund is
provided below. Calculate the total fees paid to the fund managers.

 
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Since the portfolio generated a return of 100%, which is above the 15% hard hurdle rate,
the fund managers are entitled to an incentive fee.

1. First, we calculate the management fees as $1,000,000 x 2% = $20,000.

2. We then calculate dollar return above the hard hurdle rate as [$2,000,000 –
$1,000,000 x (1+20%)] = $800,000. This is the dollar amount that the incentive
fees will be charged against.
3. Lastly, we calculate the incentive fees as $800,000 x 20% = $160,000.

Total fees paid to the fund managers are $20,000 + $160,000 = $180,000.

What are 2 and 20 (Hedge Fund Fees)?

The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a
performance fee. 2% represents a management fee which is applied to the total assets
under management. A 20% performance fee is charged on the profits that the hedge fund
generates, beyond a specified minimum threshold.

Again, the 2% fee is charged on the assets under management regardless of the

performance of the investments under the fund manager. However, the 20% fee is only
charged when the fund achieves a certain level of profit.

The graphic below should make the compensation structure clear.

 
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How the 2 and 20 Hedge Fund Fee Structure Works

The 2 and 20 fee structure helps hedge funds finance their operations. The 2% flat rate
charged on total assets under management (AUM) is used to pay staff salaries,
administrative and office expenses, and other operational expenses. The 20% performance
fee is used to reward the hedge fund’s key executives and portfolio managers. This bonus
structure is what makes hedge fund managers some of the highest paid financial
professionals.
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How the 20% Performance Fee is Calculated

The 20% performance fee is the biggest source of income for hedge funds. The
performance fee is only charged when the fund’s profits exceed a prior agreed-upon level. A
common threshold level used is 8%. That means that the hedge fund only charges the 20%
performance fee if profits for the year surpass the 8% level.

For example, assume a fund with an 8% threshold level generates a return of 15% for the
year. Then the 20% performance fee will be charged on the incremental 7% profit above
the 8% threshold. If the hedge fund manages assets of 10 large investors and makes a
sizeable profit, its income for the year may run into millions – sometimes billions – of
dollars.

Justification of the 2 and 20 Fee Structure

Some investors consider the common 2 and 20 hedge fund fee structure excessively high.
Nonetheless, the industry has generally maintained this compensation structure over the
years. It is able to do so primarily because hedge funds have consistently been able to
generate high returns for their investors. Therefore, clients have been willing to put up with
the fees, even if they consider them somewhat exorbitant, in order to obtain very favourable
returns on investment. (ROI)

Renaissance Technologies, a hedge fund managed by Jim Simmons, maintained an average

annual return of 71.8% between 1994 and 2015. Its worst year during the period still
showed a 21% profit. Because of the high yields delivered to investors, they were willing to
pay performance fees up to 44%.

Criticisms against the 2 and 20 Fee Structure

Both investors and politicians have put hedge funds under pressure for their 2 and 20
compensation structure in recent years. This is largely due to the fact that, in the wake of
the 2008 financial crisis, hedge funds – like many other investments – have struggled to
perform at optimally high levels. As a result, an increasing number of investors have sought
out hedge funds that charge fees lower than the traditional 2 and 20.

Politicians have sought a larger cut of hedge fund profits, seeking to have them taxed as
ordinary income rather than at the lower capital gains rate. As of 2018, the hedge fund
industry has been able to maintain the lower tax rate, arguing that their income is not a
fixed salary and is based on performance.

Alternative Hedge Fund Fees Structures

Some of the alternative fee structures adopted by some hedge funds are as follows:

1. Founders Shares

Start-up and emerging hedge funds offer incentives to interested investors during the early
stages of their business. These incentives are known as “founder’s shares”. The founders
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shares entitle investors to a lower fee structure, such as “1.5 and 10” rather than “2 and
20”. Another option is to use the 2 and 20 fee structure but with a promise to reduce the
fee when the fund reaches a specific milestone. For example, the fund might charge 2 and
20 on profits up to 20%, but only charge “2 and 15” on profits beyond the 20% level. 

3. Discounts for Capital Lockup

A hedge fund may decide to offer a substantial discount to investors who are willing to lock
up their investments with the company for a specified time period, such as five, seven, or 10
years. This practice is most common with hedge funds whose investments typically require
longer time frames to generate a significant ROI. In exchange for the longer lockup period,
clients benefit from a reduced fee structure.

High watermark clause

Most hedge funds include a watermark clause that states that a hedge fund manager can
only charge performance fees after the fund has generated new profits. If the fund incurs
losses, it must recover the losses before charging performance fees.