The Bottom Line on Hedge Fund Performance Fees
Data on 5,917 hedge funds over 22 years suggest that after incentive fees and management fees are assessed, investors received only 36 cents of every dollar earned on invested capital.
The hedge fund industry prides itself on its incentive compensation structure, which provides tight alignment of fund managers' and investors' incentives. Specifically, managers should receive performance fees only when investors make money. Accordingly, managers' compensation is composed of both an annual management fee and an incentive fee. The former typically ranges between 1 and 2 percent of assets under management, while the latter is often about 20 percent of earned gains. Incentive fees accrue only on gains that exceed a minimum hurdle rate — a risk-free rate — and exceed a previous high valuation. This way, investors pay incentive fees only on "new" gains.
Most Stimulus Payments Were Saved or Applied to Debt
The gap between the nominal incentive fee rate of 19 percent and the effective rate of 49.6 percent can be traced to the fee contract's asymmetric nature. The researchers identify three mechanisms at play. First, since investors pay fees at the fund level, they cannot offset losses in one fund against gains in another. Therefore, losing funds reduce investors' total profits, but not the incentive fees collected by managers. Second, investors pay fees as funds generate gains, but do not receive these fees back when funds experience losses in future years. Furthermore, many investors chase returns, meaning that they tend to withdraw capital after losses. Third, funds with consistent losses tend to liquidate, and when that happens, incentive fees paid on earlier gains are not refunded to investors.
— Linda Gorman
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