Let's say a portfolio has 22.5% more in larger bets than the benchmark, whereas another has small bets adding up to only 3%. The first portfolio, therefore, is clearly more "actively managed" than the other. Indeed, the second portfolio comes close to being an index fund. It follows, too, that the first portfolio has a greater potential to perform better than the benchmark-and also, of course, a greater potential to fare worse than the benchmark.
An investor with $100 could simulate the exposure of the first portfolio by investing $22.50 in a dollar-neutral fund and $77.50 in futures. Indeed, investors can make a portfolio as passive or as active as they wish. A completely passive portfolio would have 100% invested in the dollar-neutral fund, whereas the completely active portfolio would have 100% invested in futures.
By defining a long-only portfolio in this way, we can view fees as payment for active management-active management that can be measured and compared. In a sense, we can move from comparing onions and potatoes to comparing like with like. We've identified a common denominator.
To assess whether we are receiving what we pay for, we need to accept that we hire managers only to manage our assets actively. Beyond basic administrative fees, we would not expect to pay for the portion of a portfolio that is not actively managed. If an investor pays 0.5%, for example, for the management of the first portfolio outlined above, the fee reflects only the 22.5% of the portfolio that is actively managed. To compare the fee for that portfolio with a portfolio that would be entirely actively managed, we would divide 0.5% by 22.5, which equals 2.22%.
Similarly, if an investor pays the same amount of 0.5% for the second portfolio, then the equivalent fee, if that portfolio were entirely actively managed, would be 16.67%. This fee seems expensive compared with that of a typical hedge fund because the long-only fee would be charged regardless of the fund's profitability.
Once we put all portfolios on a common scale by evaluating the fee in proportion to the degree of active management, hedge fund fees do not appear to be much out of line. After all, hedge funds are entirely actively managed and, by their nature, usually require more buying and selling than an actively managed long-only portfolio.
The quoted rates of hedge funds may appear high, but for that rate the investor receives a higher level of active management-or even "pure" active management when compared with dollar-neutral investing.
The way in which hedge fund managers set their fees differs from manager to manager. Some hedge-fund managers will charge a bonus fee if they exceed what they call a "high-water mark." An investor will not be charged the bonus fee unless the fund exceeds the predetermined level.
Other managers will set a "hurdle." These managers agree not to receive a fee-except for the basic 1% to 2% fee-for the gains they make unless they exceed a limit. Such a limit could be the London Inter Bank Offered Rate on Eurodollars or the ten-year Treasury Bill rate, or perhaps simply a certain percentage increase.
The bonus fee is usually set for the time that has expired since payment of the previous fee. Whichever way they are set, hedge fund bonus fees always are charged for performance, on top of the management fee of 1% to 2%.