Market Insights: Why Do People Invest In Hedge Funds? [Part 3]

Welcome back! Chris Burgess here, and today, we’re wrapping up our discussion about hedge funds. Now that we know what makes a hedge fund and what a hedge fund does, we can come back to the question asked at the beginning of this series: why would anyone pay a 2% management fee and a 20% performance fee?

If you’re not already aware, hedge funds typically charge what’s called “2 and 20”. It means that investors annually get charged 2% of assets under management as well as 20% of any gains that the fund makes. Let’s break that down.

The 2% management fee gets charged no matter what. This is analogous to a mutual fund or an index fund’s management fees. It pays for all of the infrastructure for the hedge fund: the high-powered computers, Bloomberg terminals, instant access to exchange data, paying utility bills, and covering everyone’s basic salaries.

The 20% performance fee is only charged on gains, so if the fund loses money, then no performance fee is charged or, the fund charges 20% of zero; however, you want to think about it. The performance fee is pure profit for the fund managers. However, it is typical for the hedge fund manager’s contract to state that half of their performance fee has to be reinvested into the fund. So really, they only get to keep 10% of the profits.

This has two distinct advantages. The first is that the fund grows more quickly. By reinvesting some or all of the performance fee back into the fund, it can grow at a faster rate than if the full performance fee were taken out. The second advantage is that it means that the hedge fund managers have a vested interest in the performance of the fund; they only make money if the investors make money, and they are much more likely to make better decisions with the fund because their own capital is at risk alongside the investor’s money.

The last thing to cover with the fees is the idea of risk-adjusted returns. Sometimes you will hear people talk about how such-and-such hedge fund “failed to outperform the market.” This is nonsense. If you hear anyone say that, just stop listening to them. It does not matter what the market does. The hedge fund manager’s job is to provide risk-adjusted returns to their investors.

So the hedge fund might have a mandate to achieve 12% returns on 8% volatility, for example. In that case, it literally doesn’t matter if the market returned 15% because absolute returns don’t matter. The market could have had 20% volatility to achieve that 15% return, and for many investors, that’s just way too much risk. Investors in a hedge fund are investing to get a certain return on a certain risk profile. Absolute returns don’t matter. The hedge fund manager gets paid their 20% performance fee in order to get superior risk-adjusted returns. The investors in the fund signed up to take the mandated risk of 8% or less, not to take the full market risk, which could be many times that.

So who can invest in hedge funds?

Unfortunately, most hedge funds are restricted to only accredited investors, which means you must meet the requirements to be recognized as an accredited investor in order to invest in the fund. In order to be considered accredited, you must meet one of two criteria:

  1. Have a net worth of at least $1 million
  2. Make at least $200,000 per year for the last two years

If you meet one or both of those criteria, then you may be eligible to invest in a hedge fund. Luckily for you, the restriction that prevented hedge funds from promoting their services has recently been changed, so it should be much easier to get information about your options now. However, the process of actually researching, interviewing, and investing in a hedge fund is far outside the scope of this article.

That’s it for me this week! You are now far more knowledgeable about hedge funds than the average CNBC viewer. Use this information to smugly correct that guy that trades his aunt’s money and/or become an absolute blast at parties. Until next time!