Hedge fund fees explained

Hedge funds charge two kinds of fees: an annual management fee on the money invested, and a performance fee on profits. The classic arrangement is "2 and 20": a 2% management fee and a 20% performance fee. Today many funds charge less, especially newer managers and founders' share classes, but the structure is the same.

Management fee

A percentage of assets, charged whether the fund makes or loses money, usually accrued monthly or quarterly. It pays for the team, research, systems and operations. On a $500,000 investment, a 1.5% fee is $7,500 a year.

Performance fee (incentive fee or allocation)

A share of the fund's profits, commonly 10% to 20%, charged annually. In a partnership it is often structured as a performance allocation to the general partner rather than a fee. Because the manager shares in gains, U.S. rules generally limit these funds to qualified clients.

High-water mark

A high-water mark means the manager earns a performance fee only on new profits. If your account falls from $1.0 million to $900,000, the manager must earn back the $100,000 loss before charging a performance fee again. Almost all hedge funds use one; it is worth confirming in the documents.

Hurdle rate

Some funds charge a performance fee only on returns above a hurdle, such as a fixed 5% or a cash benchmark. A "hard" hurdle charges the fee only on returns above the hurdle; a "soft" hurdle charges it on all returns once the hurdle is cleared.

Expenses passed to the fund

Beyond the two fees, funds usually pay their own operating costs: administration, audit, legal, and sometimes research and technology. Some managers cap these expenses. Ask for the total expense ratio in a typical year.

Liquidity terms that affect your cost

• Lock-up: a period, often one year, during which you can't redeem, or can only redeem by paying a fee.
• Redemption frequency and notice: monthly or quarterly, with 30 to 90 days' notice.
• Gates: limits on how much can be withdrawn from the fund at one time.

Questions to ask

• What are the management and performance fees for my share class, and are there founders' terms?
• Is there a high-water mark? A hurdle? How often is the performance fee charged?
• Which expenses does the fund pay, and are they capped?
• What are the lock-up, redemption notice and gate terms?

Form D filings do not report fees, so fee terms come from the fund's offering documents. Managers who claim their HedgeMountain listing can add their terms to their fund page.

Education, not advice. This guide explains general rules and market practice. It is not legal, tax or investment advice, not an offer or solicitation, and not a recommendation of any fund. Rules change; confirm details with the SEC and a qualified professional. Disclosures