Lessons in Clarity: Hedge Funds

Hedge fund compensation is a constant source of interest for the financial media — especially the large sums of money earned by top-performing managers. Why does such substantial compensation exist in the hedge fund industry and how is it calculated?

In this article, we take a closer look at this key topic in the Investment Foundations course of study —  hedge funds (Module 4) — to better understand the incentive and compensation structures of these investment vehicles.

What Are Hedge Funds?

Hedge funds are private investment pools that investment managers organize and manage. Because they are private, access is only available to investors who meet various wealth, income, and investment knowledge criteria that each country’s regulators set.

The criteria are designed to ensure that the products are suitable for their investors. In reality, most money invested in hedge funds comes from large institutions, such as pension funds, university endowments, and sovereign wealth funds as well as from high-net-worth individuals.

Where Does the Term “Hedge” Come From?

Historically, hedge funds tended to use strategies that reduced risk by, for example, buying one asset and selling a similar asset to take advantage of the difference in their values. Although many hedge funds still engage in some hedging, it is no longer the distinguishing characteristic of hedge funds.

So, how are they different from other pooled investment products? Key differences tend to be:

  • They are available to only a limited number of select investors.
  • They have agreements that lock up investors’ capital for fixed periods.
  • Managers receive performance-based compensation.
  • They may use strategies beyond the scope of traditional mutual funds.

Performance Fees

Perhaps the most distinguishing of these characteristics is the managerial compensation scheme. Hedge fund managers generally receive an annual management fee plus a performance fee that is a specified percentage of the returns that they produce in excess of a hurdle rate. For example, a manager who receives “2 and 20” compensation will receive 2% of the value of the fund assets in management fees every year plus 20% of the return above a specified target. This specified target is the hurdle rate.

Hedge fund managers earn the performance fee only if the value of the fund is above its current high-water mark. The high-water mark is the highest level of the fund on which performance fees were paid in the past. The high-water mark ensures that investors pay the managers only for net returns on the initial investment and not for returns that merely recoup losses. This provision is sometimes called the loss-carryback provision. High-water marks apply to each investment in a hedge fund. In any given year, managers may receive performance fees from some investors but not others, depending on when each investor first invested in the fund.

The loss-carryback provision causes many managers who incur significant losses to terminate their funds and start over. Starting a new fund gives them a new high-water mark. Otherwise, they would receive no performance fee until they raised the value of the fund over the previous high-water mark. However, not all managers get the opportunity to reset their high-water marks; managers who have performed poorly in the past often have difficulty raising new funds.

Why Do Investors Tolerate High Fees?

Investors pay high performance fees in the belief that the fees provide strong incentives to managers to perform well. These incentives work when the fund is near its high-water mark. They are less powerful when the fund has performed poorly. Although many hedge funds take relatively low levels of risk, the high performance fees may encourage other fund managers to take unjustifiably high levels risks. Hedge funds may increase their risk exposure with leverage, such as through the use of borrowed money or derivatives. If their investments are successful, this leverage can substantially increase returns and the associated performance fees can make the managers extremely wealthy.

Bottom Line

If a hedge fund has poor returns, investors may lose their whole investment, but managers lose only the opportunity to stay in business. In addition, managers get to keep any fees investors paid them for previous years’ returns.