In this section, you'll find out more about how hedge funds are structured today. As the industry has evolved, the expectations from investments have evolved too, meaning structures and fees vary across hedge funds to suit the criteria of investors and fund managers.
Hedge Fund Fees
One of the key features that distinguishes hedge funds from mutual funds is their ‘2/20’ fee structure, comprising two key components:
A management fee: annual fee charged by a manager to cover the operating costs of the investment vehicle. The fee is typically 2% of a fund’s net asset value (NAV) over a 12-month period.
A performance fee: also known as an incentive fee, this second fee is viewed as a reward for positive returns. Performance fees are typically set at 20% of the fund’s profits.
Although the 2/20 structure is the more traditional model used, hedge fund managers are facing mounting pressure to reduce fees. As of 2019, Preqin has observed marginal decreases to the industry’s fee structure, to an average of 1.50% management fee and 19.00% performance fee. To ensure performance fees are not pre-emptively taken, which could trigger investors to exercise a claw-back provision, a hurdle rate and/or high-water mark can be set in place.
If a fund includes both a hurdle rate and a high-water mark, the manager cannot receive a performance fee unless the fund’s value is above the high-water mark and returns have exceed the hurdle rate.
Hedge Fund Liquidity
The dynamic nature of hedge funds strategies, which we delve into in the next lesson, allows hedge fund activity in basically anything investable. Over time, more and more strategies and fund structures have emerged. Implementing new structures was, in part, the industry’s response for the need to align interest with its investor audience. Liquidity was one of the main attractions for institutional investors, especially for those who'd had experience of the exceedingly long lock ups in the private capital world.
A fund’s liquidity will vary, corresponding with the types of investments the fund manager is pursuing. An event driven fund, for instance, would not benefit from the same liquidity provisions as a long/short equity fund. Some hedge funds may carve out a side pocket to segregate the illiquid investments from the fund’s liquid securities (offered to subsequent investors on a pro-rata basis). Others will elect for higher restrictions around capital accessibility, by decreasing the frequency of periodic withdrawal and increasing notice periods.
While hedge fund managers can offer a fraction of the wait time compared to their closed-end counterparts, their liquidity terms are still binding in comparison to the traditional mutual or exchange-traded fund. So, while a CTA/Managed Futures strategy can be characterized as having a relatively short investment horizon, its redemption frequency is not daily. Money that ‘sticks’ is most desirable – managers can then concentrate more on managing and spend less time dealing with panicky investors.
Explore the types of restrictions that impact liquidity by clicking on the drop-down menu below.
Maximum Leverage Employed
Hedge Fund Leverage
How and Why do Hedge Funds Use Leverage?
Leverage is generally described as the use of debt to amplify returns, but at a higher risk profile. Hedge funds use leverage for a few different reasons: to 1) bolster returns at a higher risk with a potentially much higher reward, 2) amplify low-risk strategy returns, 3) reduce risk levels, or for 4) improved liquidity and lower transaction cost reasons.
Type of leverage used depends on hedge fund strategy. A manager would choose to boost returns at a high risk with leverage if they were highly confident in an investment thesis, typically a long bias equity fund. A different manager would choose to boost lower risk returns, such as arbitrage trades, which are usually hedged and have less downside but provide little return without leverage. Leverage with the purpose of risk mitigation is common across all funds. For example, a long/short equity fund would balance out its long exposure with short positions, resulting in less volatility. Liquidity benefits can be directly experienced in the commodities market, where taking positions in derivatives is much more efficient than the commodity itself.
The Mechanics Behind Leverage Tools
The most common explicit leverage method is through shorting. The fund manager can select which securities the fund will sell short and immediately receive cash for their selection. This cash can be used to buy more assets, ultimately resulting in more assets purchased than the fund originally could have bought without the extra cash. The manager must buy the shorted security back later, so there is a risk of price appreciation of the underlying security, which would drain cash in the future.
Another explicit form of leverage is available to hedge funds through their prime broker, most of which can offer credit (buying power to purchase assets) in exchange for a smaller fixed percentage of the fund’s cash/securities and a fee. Implicit leverage can be obtained through the use of derivatives, such as futures, options, forwards, and swaps. Leverage is used to expose the trader to amplified price movements in the underlying security without having to put up the capital that would be needed in the underlying’s market (i.e., buying a call option exposes the buyer to the price movement of 100 shares of an equity, but at a small fraction of the cost). The fund can then put capital saved to work in other ways to generate returns.
Types of Hedge Funds
There are a range of different hedge fund vehicle types and structures available for investment. Fund types vary in order to meet investors’ needs like liquidity, limited liability, and tax exemptions.
Explore the key fund types in the dropdown.
Undertakings for Collective Investment in Transferable Securities (UCITS)
Hedge Fund Structures
Hedge funds can be structured in various ways depending on a number of factors, including where the fund is domiciled (the country in which it is registered), where its investors are located, and the fund’s investment criteria.
Other Legal Structures
There are other legal structures in hedge funds. These include open-ended investment companies (OEIC): a fund structured to invest in other companies, with the ability to constantly adjust its investment criteria and fund size. SICAV (société d'Investissement à capital variable) is a common fund structure throughout Western Europe. Also, QIF (qualifying investor fund), which is a regulated vehicle aimed at Ireland-based investors, allowing the use of leverage and holding of derivative products.
For a full list of our hedge fund structures, see our Preqin Glossary.
In this lesson, we explored hedge fund fees and how they are split between both management and performance fees. We covered the different aspects of the fee structure, and how rules in place prevent managers from charging too many fees. We explained the time commitment involved in these kinds of investments, and took you through the different types of hedge funds.
