Hedge Funds – Where are the Customers’ Yachts?

October 30, 2012 in Hedging and Hedge Funds

Hedge funds Broker commissions and profits

An oft-quoted nugget from financial literature goes as follows:

A young man, about to be recruited into the financial markets, was being shown around New York and was shown some smart yachts anchored at the Battery. “Those are the yachts owned by the bankers, and there, those are the ones owned by the brokers,” said his guide.

“Nice,” said the novice, who then naively asked, “And… where are the customers’ yachts?”

The anecdote above is quoted here, in this chapter on the fees charged by hedge funds.

How do hedge funds charge their investors?

Most commonly, the fees charged by a hedge fund are of two kinds. One is a “management fee,” charged to meet the costs of operating and maintaining the fund. This fee is charged as a percentage of the value of assets under management, and is most often levied on a quarterly basis. The fee varies from fund to fund, but is usually in the range 1 – 2%.

The other fee, known as a “performance fee,” is charged by the fund for generating the returns on the investor’s fund, and is a sort of incentive payment for the deployment of the skills of the hedge fund manager. Calculated as a percentage of the profits achieved, the fee is governed by the terms and conditions specified in the offer documents of the fund. In some cases these fees are only payable if the manager grows the assets (i.e. earns returns) above the previous “high water mark,” i.e. the previous level up to which the manager has been paid the performance fee. Since the manager is not required to refund fees in the case of losses, new fees become payable only when the losses are recouped and the fund value becomes profitable again by crossing the high water mark.

Again, some terms specify that performance fees would be payable only on returns earned in excess of a certain, usually risk-free rate of return, called a “benchmark” rate.

The performance fee also varies from fund to fund, but the most common levy is 20% of the growth achieved.

From the above it is clear that the standard hedge fund fees structure is usually a 2% management fee plus a 20% performance fee – in hedge fund parlance this is known as a “two-and-twenty” structure.

It is imperative that you understand the implications of the fee plan. Get this: As an investor in a two-and-twenty fund, you will only earn returns after the hedge fund fees are paid. That means the hedge fund has to earn very high returns. That’s a tall order when world-wide interest rates are ruling at near-zero rates. This means that the manager will have to take very high risks with your money.

This also means that the manager has to be very good at reading and trading the markets.

This also means that you have to be doubly careful about the selection of your hedge fund.

Let us illustrate the two-and-twenty structure with an example below, which shows a fund starting with an investment of $1 billion and its performance for six years:

Starting AUM (Assets Under Management):
1000000000

2003

2004

2005

2006

2007

2008

Return %

25%

10%

2%

15%

5%

-40%

Gross Aum

1250000000

1298000000

1275816000

1432666320

1438895304

838670406

Fees*

70000000

47200000

30019200

62289840

41111294

27955680

Net AUM

1180000000

1250800000

1245796800

1370376480

1397784010

810714726

*Fees Calculation
Growth Amount

250000000

118000000

25016000

186869520

68518824

-559113604

Perf fee (On Growth Amt)

20%

50000000

23600000

5003200

37373904

13703765

Mgt Fee (On Opg. AUM)

2%

20000000

23600000

25016000

24915936

27407530

27955680

Total Fee

70000000

47200000

30019200

62289840

41111294

27955680

Net Result After 6 Years
Client Earnings

-189285274

Hedge Fund Mgr Earnings

278576015

 

See the point? After six years, the client had a loss of $189 million to show for the money invested and risks assumed. On the other hand, the hedge fund managers romped home with $279 million in fees.

No surprises then that there were no customers’ yachts in the harbor!

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