How Hedge Funds Makes Money ?
The inner workings of hedge funds are as elusive as their outward appearance. The general public usually does not know how hedge funds generate revenue and how they manage to pay their employees record salaries and pay rent for the prime properties where their offices are located. The general population is unaware of the various fees that are charged by the funds to their investors and how investors continue to make money despite this big barrage of fees levied on them.
This article will explain the several types of fee that are charged by the hedge funds in order to sustain their operations.
Management fee is the revenue that keeps the operation of the hedge fund going. The rent of the hedge funds office, the salary of hedge funds staff and all other operational expenses are made out of the management fee. The management fee is usually in the range of 1% to 2% of assets under management. Although this fee is expressed as an annual figure, it is usually charged monthly. Management fee as a percentage of assets under management is reduced as the size of the fund gets bigger. This is what gives bigger hedge funds the benefit of economies of scale and results in lower transaction costs for the investors.
Also, the management fee is charged on the value of investors equity in the fund. Therefore if the fund experiences a loss and the value of the assets go down, so does the fee generated by the management. This ensures that the incentives of the management are aligned with that of the investors.
Incentive fee is charged by the hedge fund management based on the performance of the fund. For instance, if the fund generates a return of 25% on assets under management, then a portion of the 25% is retained by the hedge fund management as their incentive. Usually, this works out to about 20% of the profits generated.
The incentive fee is a used by all hedge funds. This fee ensures that the incentives of the investors as well as management are aligned i.e. the management treats the investors money like their own.
Many investors feel that it would be inappropriate for the hedge funds to charge an incentive fee on any and every return that they generate. For instance if the fund generates a 3% return and the management charge a 20% incentive fee on that, it would be unfair.
A low rate like 3% can be generated by investing in a risk free security like treasury bonds as well. This kind of dismal performance should not be rewarded.
Therefore, these funds follow the concept of a hurdle rate. This rate is the minimum benchmark which is expected from the fund. Performance above this benchmark is rewarded with an incentive fee. However, performance up to this level is ignored. For instance, if 3% is the hurdle rate and the fund generates 8% return. In this case, the incentive fee would be charged on the additional 5% only and not the entire 8%.
Hedge funds provide investors with an opportunity to divest their money whenever they feel that the fund is not doing well. Such meetings are usually held monthly. However, if one investor decided to pull out his/her money, the interests of the other investors are affected too.
For instance, there are transaction costs incurred while liquidating the money. Also, the total budget is reduced and hence the investment strategy has to be modified. To recover these costs as well as to deter the investors from withdrawing their money, a surrender fee is charged to the client. However, many funds that are very confident about their performance usually do not charge such a fee.
Hedge fund investors are wary of the management charging them extra fee even though their investments are not growing. For instance, if the value of a stock goes up by 20%, then falls back 10% and rises again to reach the same level, the hedge fund might charge the incentive fee twice, even though the value of the stock is range bound and not increasing all the time.
It is for this reason, that each time the value of investment sets a new high, it is considered as a threshold. Next time the incentive fee is only paid using the value of that threshold as the base price. Range bound movements do not entitle the fund to receive.
Hedge fund management usually does not refund the incentive fees that they have charged in general. However, some hedge funds want to attract more clients. Therefore, if the fund incurs a loss and the incentive fee has been charged, the fund management returns a portion of the fee that it had earlier collected. This is done to convince the investors that the hedge fund does understand their interests and is fully committed to it.
Some hedge funds are highly leveraged. Obtaining such leverage costs money in the form of interest payments. Hence, these funds charge these payments to the investors in the form of a financing fee.
Apart from the above mentioned fee, there are a multitude of fees that might be charged by the fund to the investors on a case to case basis. However, despite these several fees investors still make a lot of money compared to other investment options. This is the reason why they eagerly invest in these funds.
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