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A closer look at hedge fund fees

The latest research from research company Fitzrovia highlights significant variations in the way hedge funds' performance fees are structured.

The research highlights the importance of assessing hedge fund fees beyond simply referring to the much-used "2 and 20" - both for their impact on returns and on fund company revenues. For example, around one third of alternative investment funds in the research charge a performance fee at a level other than 20 per cent of net gains.

A total of 18 per cent of alternative investment funds in the research have a hurdle rate in place, whereby a performance fee will only be achieved once the manager has exceeded a risk-free rate ('hurdle') of return.

The research also reveals that 87 per cent of alternative investment funds in the research use a high water mark. This aims to avoid volatility being unfairly rewarded by ensuring that shareholders do not pay performance fees on a recovery of performance to a previous high.

At the same time, only 2 per cent of alternative investment funds with a high water mark reset it after a defined period of time, while the vast majority choose to make it 'permanent'. In Fitzrovia's view, it could be to the benefit of both managers and investors if this mark was reset after a period of one to three years.

Fitzrovia said use of this latest research should help hedge funds to take a more pro-active approach to their fiduciary responsibilities and to address criticisms of their fee structures, sometimes referred to as "heads I win, tails you lose" (for example, in a footnote in the SEC Staff report, 'Implications of the Growth of Hedge Funds').

Fitzrovia's Performance Fee Checklist:

* How is the performance fee calculated? For example: the percentage of net gains or percentage of net assets that would be charged.

* Is there a hurdle rate? If so, what is the fixed level or variable rate? A performance fee will only be achieved once the manager has exceeded a risk-free rate ('hurdle') of return.

* Is there a High Water Mark? If so, what is its duration? To avoid volatility being unfairly rewarded, this mechanism aims to ensure that shareholders pay performance fees only on new net gains, i.e. that they cannot pay for the same absolute increase if the net asset value per share rises, falls and then recovers.

* Is there an equalisation system in place? Equalisation is the broad term used for splitting performance fees fairly between existing and new investors over a period, by doing so at individual shareholder level.

* Is there a fee cap? If so, what is it? Limiting the percentage of a fund's net assets - not just of the net gains - that the performance fee can attain.

Background Note: Fitzrovia's report "Benchmarking Performance Fees" analyses the performance fee structures of 2,422 funds, of which 393 are alternative investment funds.

Of the alternative investment funds in this research, the straight mean average annual management charge is 1.47 per cent.

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