How much will I pay in fees on a hedge fund?

Hedge funds are typically the most expensive collective investment scheme funds in which to invest and you should be comfortable that the fees are justified because you earn returns you cannot earn anywhere else.

Hedge funds typically charge both a fixed asset management fee and a performance fee. The performance fee varies depending on the performance the fund achieves.

You may have seen references to hedge funds charging according to the “two-and-20 rule” – referring to an ongoing annual management fee of two percent of the amount you have invested and a performance fee of 20 percent of all performance above a stated performance benchmark or fee hurdle (the level of performance the fund must achieve before a performance fee applies). Read more: How performance fees are calculated

An industry hedge fund survey, however, shows most South African funds charge a lower annual management fee of one percent and a performance fee of 20 percent of any outperformance of the hurdle.

There are still funds, thought, that charge an ongoing fee in excess of one percent – some as high as 2.5 percent. And there are funds with performance fees with a 20% participation rate.

When you assess the fees a hedge fund charges, you need to establish:

• What is the annual management fee?
• What is the performance hurdle?
• What is the measurement period for the hurdle and what fee applies above the hurdle?
• Is the performance fee uncapped? This means that, regardless of how high the return, you will pay the performance fee – for example, 20 percent – on the portion above the hurdle.
• What happens to the performance fee when performance is negative – is some of the fee paid back to the investor (clawed back)?

Performance fees are complex, and you may need professional advice to establish whether the potential return is likely to justify the fees.

Hedge funds are now, like other collective investment schemes, obliged to report their fees on a quarterly basis as a total expense ratio (TER). Remember that TERs are a backward-looking measure of costs and will be high when the performance of a fund has been good.  Read more: How do I measure costs on my unit trust fund?

Hedge fund managers justify charging higher fees because hedge funds have:

• Have higher operational and regulatory costs than unit trust fund managers.
• Additional expenses financing short trades, and gearing.
• Additional research costs into strategies and typically under-researched sectors.
• Smaller amounts invested in them than many unit trust funds.