IFT Notes for Level I CFA® Program
R50 Introduction to Alternative Investments
3.3. Hedge Fund Fees and Other Considerations
Investors must consider the fee structure before making an investment in hedge funds. Common fee structure is 2 and 20 which means 2% management fee and 20% incentive fee. Funds of funds charge an additional 1 and 10 fee (1% management fee and 10% incentive fee).
- Incentive fee is usually calculated on profits net of management fees or on profits before management fees.
- Generally, the incentive fee is paid only if the returns exceed a hurdle rate.
- In some cases, the incentive fee is paid only if the fund has crossed the high water mark. A high water mark is the highest value net of fees (or the highest cumulative return) reported by the fund so far for each of its investors. This is to ensure investors do not pay twice for the same performance.
Some other considerations are discussed below:
Hedge funds may use leverage to seek high returns
- Leverage magnifies losses and gains.
- They are required to put up collateral when using derivatives. If the position incurs a loss, then the collateral acts as a safeguard against any default. The amount of collateral depends on the creditworthiness of the investor.
- Generally, hedge funds trade through prime brokers who provide services like administration, lending, short borrowing, and trading. The hedge fund deposits cash or other collateral into a margin account with the prime broker, and the prime broker essentially lends the hedge fund the shares, bonds, or derivatives to make additional investments. The margin requirements, interest, and fees are negotiated with the prime broker(s).
Redemptions can magnify losses
- Occurs if a fund is performing poorly.
- Drawdowns (decline in NAV to below the high-water mark) might trigger redemptions.
- Redemption may require hedge fund managers to liquidate positions and incur transaction costs.
- Redemption fees, notice periods, and lock-up periods seek to minimize impact of drawdowns.
- Funds of funds offer more redemption flexibility.
- Hedge funds are subject to relatively low regulation. Low regulation is one of the reasons why they are not transparent with respect to strategies or reporting returns.
- Hedge funds are often registered in offshore locales such as the Cayman Islands.
Consider a hedge fund with an initial investment of 200 million; the fee structure is 2 and 20 and is based on year-end valuation. In year 1, the return is 30%.
- What is the total fee if management fee and incentive fee are calculated independently? What is the investor’s effective return?
- What is the total fee if the incentive fee is calculated after deducting the management fee? Investor’s net return?
- If there is a hurdle rate of 5% and fees are based on returns of in excess of 5%, what is the total fee? What is the investor’s net return?
- In the second year, the fund declines to 220 million. Assume that management fee and incentive fee are calculated independently as indicated in Part 1, but now a high water mark is also used in fee calculations. What is the total fee? What is the investor’s net return?
- In the third year, the fund value increases to 256 million. What is the total fee and investor’s net return?
- Initial investment grows to: 200 x 1.3 = $260 million.
Profit = $60 million.Management fee: 0.02 x 260 = $5.2 million.Incentive fee which is 20% of profit = 20% x 60 = $12 million.Total fee = $5.2 million + $12 million = $17.2 million.Investor’s return = = 21.4%
- Incentive fee after deducting management fee = 20% x (260 – 200 – 5.2) = 10.96.
Total fee = 5.2 + 10.96 = $16.16 million.Investor’s return = = 21.92%.As you can see the return is better than Part 1 because incentive fee paid is relatively less here.
- There is a hurdle rate of 5%. So, 200 x 0.05 = $10 million must be subtracted before incentive fees are paid.
Incentive fee = 0.2 x (260 – 200 – 5.2 – 10) = 8.96.Total fee = 5.20 + 8.96 = $14.16 million.Incentive fee is further reduced and the investor’s return is enhanced.Investor’s return = = 22.92%.
- Management fee = 0.02 x 220 = 4.4. To calculate the incentive fee, we need to determine whether the fund value has exceeded the high water mark. The high water mark was achieved at the end of Year 1. This value was 260 million – 17.2 million = 242.8 million. The incentive fee is 0 because the fund value is below the high water mark. Hence the total fee = $4.4 million.
Investor’s return = = -11.2%
- Management fee = 256 x .02 = 5.12. Since $256 has exceeded high water mark of 242.8 million, an incentive fee would be paid. Incentive fee = (256 – 242.8) x 0.2 = 2.64. Total fee = 5.12 + 2.64 = 7.76 million.
Investor’s net return = = 15.14%.
An investor is contemplating investing £200 million in either the Hedge Fund (HF) or the Fund of Funds (FOF). FOF has a “1 and 10” fee structure and invests 10% of its assets under management in HF. HF has a standard “2 and 20” fee structure with no hurdle rate. Management fees are calculated on an annual basis on assets under management at the beginning of the year. Management fees and incentive fees are calculated independently. HF has a 25% return for the year before management and incentive fees.
- Calculate the return to the investor of investing directly in HF.
- Calculate the return to the investor of investing in FOF. Assume that the other investments in the FOF portfolio generate the same return before management fees as HF and have the same fee structure as HF.
Solution to 1:
HF has a profit before fees on a £200 million investment of £50 million (= 200 million × 25%). The management fee is £4 million (= 200 million × 2%) and the incentive fee is £10 million (= 50 million × 20%). The return to investor is 18% (= (50 – 4 – 10) / 200).
Solution to 2:
FOF earns an 18% return or £36 million profit after fees on £200 million invested with hedge funds. FOF charges the investor a management fee of £2 million (= 200 million × 1%) and an incentive fee of £3.6 million (= 36 million × 10%). The return to the investor is 15.2% (= (36 – 2 -3.6) / 200).
The hedge fund had an initial investment of $60 million. At the end of the first year, the value was 70 million after fees. At the end of the second year, the value was 80 million before fees. The fund has a 2 and 20 fee structure and incentive fees are calculated using a high water mark and a soft hurdle rate of 5%. Calculate the total fee paid for year 2.
Management fee = 80 x .02 = 1.6 million
Incentive fee = (80 – 70) x .2 = 2 million
Total fee = 1.6 + 2 = 3.6 million
3.4. Hedge Fund Valuation Issues
Hedge funds are valued on a daily, weekly, monthly, and/or quarterly basis.
The value of a hedge fund depends on the value of underlying positions.
The price used for valuation depends on whether market prices are available and if the underlying position is liquid. There are three possibilities:
- Market prices available for underlying liquid positions: When market prices are available, the fund decides what price to use. Common practice is to quote at . A conservative approach is to use bid prices for long and ask prices for short.
- Market prices are not available for underlying illiquid positions: Estimated values calculated through statistical models are used.
- Market prices are available for underlying illiquid positions: A liquidity discount or haircut must be considered to reflect fair value. Some funds report two NAVs: trading and reporting. Trading NAV incorporates liquidity discounts. Reporting NAV is based on quoted prices.
3.5. Due Diligence for Investing in Hedge Funds
Key due diligence points to consider are divided into two categories:
Quantitative due diligence:
- Investment strategy: In which markets does the hedge fund invest in? What is the strategy – long/short, relative arbitrage, market neutral, etc.? Is the performance repeatable?
- Investment process: How is the strategy implemented?
- Competitive advantage: A lot of information is considered proprietary (the reason behind a fund’s performance) which the fund may not be willing to share freely with outsiders.
- Track record: How are the returns calculated and reported; what are the fees? Is the historical performance data readily available? It is an indicator of future performance. Investors expect a minimum track record of two years.
- Size and longevity: If a fund has existed for a long time then this implies that it has not caused significant losses to investors.
Qualitative due diligence:
- Management: Is the management skilled and accountable to the fund?
- Key person risk: What is the compensation for the key people in the firm? Is there a big incentive for them to stay with the firm? How many people have left the firm recently, and why?
- Reputation: Is the fund manager reputed? Does he have the necessary experience/pedigree to manage the fund? What has his contribution been in the performance?
- Investor relations: Is the fund proactive in sharing information (transparent) with its investors in an effort to strengthen the relationship?
- Plans for growth.
- Systems risk management: Can the fund manager explain the risks taken? Are you satisfied with the answers given, or do you think something is being hidden?
- Prime broker: Who is the prime broker, and who is the custodian for securities?