Fees associated with hedge funds

There is no singular, all-encompassing fee associated with hedge funds. The funds span a variety of strategies and different investment types – everything from stocks to startups — and depending on what type of money manager the investor uses, the fees may vary. However, the common fees associated with hedge funds are as follows:

• Management fee – this is basic, and is usually determined annually, though it may be paid out on a monthly basis. It will often be determined by the “two and twenty” (2% and 20%) factor. The “two and twenty” fee factor will apply to both the performance (see below) and the management fee; in such cases, two percent is taken annually from the fund’s net assets, and the twenty percent is taken from the annual profit made on the hedge fund.

• Performance fee (also known as an incentive fee) – this is also a very basic fee that money managers (usually limited liability companies or limited partnerships) require for their services. Be careful to distinguish a performance fee from a management fee; they are two different fees, though they are often seen as a package deal, especially since two and twenty percent scenarios are so common.

• Hurdle rates – this type of fee is sort of the baseline for rates of return. They are used to help determine performance rates, weighing the performance of the hedge fund investment overall against market standards. If hurdle rates are put in place as part of a hedge fund partnership, sometimes the performance fee will not be paid unless the return rate equals or surpasses the standards agreed upon. Hurdle rates were introduced to make certain that compensation will still occur, even if the returns do not exceed investment amounts.

• Withdrawal fees – this is not quite as common as the perfunctory performance and management fees, or even hurdle rates. Withdrawal fees occur when money is withdrawn from a hedge fund (hence the name). There may also be fees for withdrawing over an allotted amount of money, or for withdrawing too soon. Generally, this fee exists to discourage investors from withdrawing funds from the hedge fund frequently.

Keep in mind that every hedge fund situation may be different. The money manager may not charge a two and twenty percent fee for their services and may have alternate rates. Specific questions about a money manager’s fees and practices should be directed to the company. There may also be additional fees not mentioned here. It is important to thoroughly discuss fee practices with partners and companies before making any decisions – and especially before making any investments.

Fees are in place to make sure that the money manager has been compensated for their time, effort, and expertise – and also to help incentive them to make the best possible investments with hedge fund money. The higher the returns, the more money the hedge fund manager will be able to pocket at the end of the day. Successful hedge fund partnerships are beneficial for both parties, though the investor and the money manager play very different roles.

What is a hedge fund?

A hedge fund is a specific type of investment fund that is typically the domain of investors with a lot of experience. The reason why a hedge fund is perhaps better suited to a sophisticated investor is because the investors often have to fulfill certain requirements in order to be considered accredited/qualified. Hedge funds are also primarily run by a limited partnership, or a limited liability company, which places a money manager in charge of making decisions about investments made with the hedge fund.

For your average investor, a hedge fund would not be something they deal with, due to the fund’s complicated nature. For those with investment experience (and a lot of money to invest), hedge fund investments can be lucrative. A hedge fund has the benefit of being extremely versatile, and works in many ways like an entire portfolio; the money manager can choose to invest in a variety of different areas in order to maximize return under any market conditions. Hedge fund investments deal with more than just stocks, bonds and basic trading – hedge fund investments can be used to support startups, currency, and much more. Essentially, anywhere a money manager sees the opportunity to reap huge gains at little risk; a hedge fund investment may take place. This can involve either short or long positions. Hedge fund investments can be centered on one country, or can reach a global scale – it is up to the wisdom of the money manager to decide what market to engage in.

For the most part, most hedge funds are unregulated as many states do not require registration with the Securities and Exchange Commission. However, despite the “unregulated” status, the money managers (who are skilled investment professionals) are indeed required to adhere to the same market regulations as everyone else as they go about the business of managing the hedge fund portfolio. There is nothing illegal or dubious about hedge funds, when properly managed.

The term “hedge fund” refers in some cases to “hedging” against the market, or deliberately using techniques designed to reduce financial risk. In recent years, however, the “hedging” side of hedge funds (i.e., reducing risk as much as possible in terms of investment choices) has become rather fluid. Some money managers prefer to invest in volatile, fast-moving markets because the returns can be even more substantial.

Because of the many different financial techniques employed by hedge fund experts, there is no single definition or example of a hedge fund to be found. Some portfolios may reflect a cautious financial mind, and some may be far more adventurous. A good hedge fund manager will do their best to combine several strategies for making big returns at once, rather than relying on one method. Many hedge fund managers have an area of expertise and will focus on their field of skill. When entering into a hedge fund partnership as an investor, be sure to know exactly what the portfolio manager specializes in, and how much experience they have with hedge fund investments in total.

Hedge Fund structure

No one hedge fund is structured like any other. There are a number of factors that come into play, mostly having to do with what state (or even country) the hedge fund is located in, the hedge fund manager’s practices, policies, and specific skill set, and of course the amount of money in the fund itself. Furthermore, the diversity of the investments in the hedge fund changes the structure of the hedge fund as well a typical, well-managed portfolio has more than one type of investment at a time. In a way, hedge fund investments can be “mixed and matched” in order to achieve the best results. Investment managers can use a risk parity strategy with one investment, and on another use fixed income arbitrage, for example.

Typically, a hedge fund is comprised of an investor (either an individual or a company), and the investor enters into a partnership with the hedge fund money manager – or (when there are multiple parties) else enters into a company with the manager. Once established, the hedge fund company will make investments; this is the hands-on part of the partnership or company. The investor virtually has no role in the investment process, and is not nearly as involved in the decision making, business practices part of the hedge fund.

Other people may provide services in a hedge fund as well. These may include a distributor, who primarily markets the funds to investors; a prime broker, who do the majority of the work with lending money and securities; and an administrator, who handles the withdrawals and subscriptions of investors. This is a very basic outline of what various people within the hedge fund may do, and every hedge fund is different. A hedge fund never has any employees or assets other than the investments within the fund itself.

The taxation and regulation of hedge funds varies greatly depending on the location of the fund itself. For example, hedge funds in America are considered very loosely regulated (they typically do not have to report to SEC, for one). A lot of hedge fund companies take advantage of tax opportunities by establishing the fund in an offshore financial center, so that the investor pays taxes on the portfolio, and it doesn’t come out of the fund itself. However, despite many hedge funds being technically located offshore, a lot of investment managers are located onshore.

Legally, hedge funds are usually formed as limited partnerships, or limited liability companies. The general partner is the investment/money manager, and the limited partner(s) is the investor themselves. Hedge funds are considered private investments and are not held up to the same amount of regulation that other investments are. While hedge funds are often referred to as “unregulated,” the fact is that there is some regulation that has to take place by law – it is simply different than regulation for other types of investment. An example of how hedge fund regulation functions is that investors are heavily scrutinized and must meet certain criteria before being approved.

Market trends of Hedge Fund industry

Hedge fund trends tend to change over time – hence why they’re trends! Hedge funds themselves have a long and storied history of changing over time; think of the massive diversification into the internet with the Dot Com boom, and more recently, the newest regulations with the Dodd-Frank Act reshaping traditional hedge funds as we know them. Recent hedge fund trends are all over the map (and there is no guarantee that these trends will continue), but here is a small selection:

• Hedge funds in the early part of 2013 have shown a move toward global markets. The fact that hedge funds have a very large global presence, and that there is virtually no limit to what kind of investments can be made inside of a hedge fund portfolio, means that now is the perfect time to invest in emerging global markets.

• The uber rich have been careful with their assets lately, seemingly looking to protect themselves against margin calls and looming finance changes. Many hedge funds have taken their assets out of funds in the form of cash. Hedge fund portfolios are still going strong, though, with 2012 seeing the best performance in the beginning of a year since 2006.

• Managed futures are up, as are global macros!

• Larger funds are seeing larger inflows. Small funds are still mostly experiencing redemptions, but not the kind of net inflows that larger funds are seeing. The number stands as funds with more than one billion dollars in assets receiving 78% of inflows.

• Hedge funds that beat their ‘peers’ in 2012 had similar results in 2013 – at least thus far. 57% of those peer-beating funds saw net inflows in the first quarter.

• The trend did seem to be that those hedge funds which saw positive results in 2012 continued to do so into 2013. The majority of large hedge funds saw net inflows in the first quarter of 2012, where 63% of mid-size funds with positive performance in 2011 saw net inflows into 2012.

• There was a marked trend of investors who discovered their investments had under-performed shifting out of them and heading for seemingly greener pastures. This is usually the case (no investor typically has the patience to “hang around” an under performing fund), but the numbers were higher in the first quarter of 2013.

One of the biggest changes of 2012, leading into 2013, is the continued implementation of the government’s insider trading charges and other legal actions. Some funds have closed, many managers are under investigation, and some funds are doing poorly in general due to the continued investigation and allegations. While it is true that some funds have had a rough year so far, a good portion of funds are seeing decent to good profits on their invested assets. It remains to be seen if these positive trends will continue through the rest of 2012. It is evident to some that in the wake of the Dodd-Frank Act that regulation may begin to increase on hedge fund investments across the globe.