Management fees: The investment advisor to a hedge fund is usually paid based on an asset-based fee, similar to fees charged by advisors to registered investment vehicles. More than 70% of the managers charge between 1% and 2% of the asset value, with some funds as high as 6%7.
Incentive fees: In a hedge fund, incentive fees are based on the fund's net investment income, realized capital gains and unrealized capital appreciation. These fees are paid back to the general partner of the fund and can be well over 20%8 of the realized and unrealized gains. While 87% of the funds that we reviewed received a participation rate of 20% of the fund's performance, some were more than 45%.
In a few cases incentive fees are only paid after reaching certain thresholds of performance (benchmarks), so as to protect investors from paying for poor performance. The benchmark acts as a minimum performance bogey before the investment advisor can receive payment beyond the management fee. Most funds have a high-water mark that establishes a baseline each year from which to assess the following year's performance. For example, let's assume an investor in a fund has a net asset value of $1 million and a return of 20% in one year. The next year the fund loses money. Since the fund lost money, there is no performance fee. In fact, the investor will not owe an incentive fee until the fund has had gains such that the net asset value exceeds the high-water mark of $1.2 million.
Also, in some funds the investor pays for certain administrative, legal and accounting fees. Some funds do not charge a management fee, but instead charge all expenses to the fund. These can be more than 5% of the assets under management. Hedge funds charge a formation expense but, unlike mutual funds, they do not amortize over a period of time.
If returns are reported after all fees and expenses, should an investor care as long as performance is adequate? There is no right or wrong answer, but the question should give an investor pause to understand hedge funds as a business. Regardless of how good a fund's performance is or how bright the fund managers are, if the investment firm goes out of business the investor will not benefit. In many cases, especially small funds, the performance fee can be an important source of paying the rent, paying for critical technology and databases and meeting staff expenses. In the absence of the incentive fee the fund may lose key personnel, resulting in continued poor performance or termination of business. Establishing the right mix of management fees and performance incentives is a delicate exercise. If fees are too high at the same time that performance is poor, the survivorship of the fund may be in question.
Is Performance Audited?
Because hedge funds are private placement securities and are not registered, there is no formal requirement to have the results audited. It is usually left to the investors and the investment advisor to agree on issuing audited financial results. Auditors review compliance with general accounting principles and render an opinion as such. Auditors do not verify the accuracy of how securities are priced. While we suggest that investors push for audited performance results, that will still not guarantee that results are of the highest standards.
Observations And Conclusions
We have discussed the many pitfalls of databases, the dispersion of returns, the impact of fees and the lack of persistence of performance. An investor could wonder if returns have any value at all in the decision-making process. Relative performance may be of little value, but the pattern of returns and how the returns are generated are very important in understanding the appropriateness and desirability of a specific fund. The pattern of returns will be the subject of the next article, which will discuss the many aspects of performance risk that an investor should consider. Due to the complexity of hedge fund strategies, we believe that due diligence should be completed with the help of a qualified investment professional.
What should advisors and investors ask about performance and the pitfalls of relying solely on published peer universes and databases to make investment decisions? We recommend asking hard questions about performance. Most importantly, the investor should have little interest in recent relative returns, but should understand how the returns were generated and the historical pattern of returns. The study of the pattern of returns becomes the study of investment risk.
Risk is more than a simple calculation of standard deviation. The measurement should consider downside risk, distributions of returns and how a specific fund may diversify risk in a portfolio of hedge funds and other investments. Importantly, we strongly suggest analyzing drawdown and to get to know the potential downside of a manager's strategy. In a subsequent article we will shift the discussion toward this important topic. Using the concept of drawdown, we will further explain its implications regarding risk taking and help investors sort out whether or not a particular hedge fund strategy is suitable for their needs.
Eileen Cohen is a portfolio manager for JP Morgan Fleming Asset Management in New York. William H. Overgard is president of WHO Investment Consulting in Wilton, Conn., (203) 834-2871.