In 2022 the average hedge fund in filings to the US Securities and Exchange Commission (SEC) lost 3.0% before fees and 4.3% after them. The gap is the fees and expenses the funds charged. A management fee is charged in a losing year too.
A hedge fund usually charges two fees: a management fee on its assets and a performance fee on its profit. This guide explains both, then shows how a high-water mark limits the performance fee and what a four-year example costs an investor.
What does a hedge fund charge? A hedge fund usually charges a yearly management fee and a performance fee on profit. A high-water mark limits when the performance fee applies.
Investor.gov, the SEC's investor education site, gives typical fees of 1% to 2% of net asset value (NAV, the fund's assets minus its debts) and 15% to 20% of profit.
A high-water mark is the highest value an investor's holding has reached. The fund can charge a performance fee only on gains above it, so a loss must be recovered first.
In our example, a $100 million fund paid $12.68 million in fees over four years. The investor's gain after fees was 55% of the gain before fees.
What 2 and 20 means
The management fee is a percentage of the fund's net assets, charged every year. The performance fee is a share of the profit. "2 and 20" is shorthand for a 2% management fee and a 20% performance fee.
Investor.gov gives typical management fees of 1% to 2% of NAV and performance fees of 15% to 20% of profit. A 2003 SEC staff report on hedge funds gave a management fee of generally 1% to 2% of net assets, with performance fees tending to be 20%.
A fund of funds invests in other hedge funds, so it adds a second layer of charges. The 2003 report put those at about 0.5% to 2% a year plus up to 20% of profit, on top of the underlying funds' fees.
We explain what these funds are in What Is a Hedge Fund?
What a high-water mark is
The SEC's 2003 staff report describes a high-water mark as a threshold the adviser must pass before a performance fee can be charged. It "prohibits an adviser from collecting an incentive allocation twice for the same performance".
The mark generally varies for each investor, based on the highest value of that investor's holding since the first investment. After a loss, the fund must climb back above the previous high before it charges a performance fee again.
Academic work describes the same contract. Goetzmann, Ingersoll and Ross (2003, Journal of Finance) study a performance fee conditioned "upon exceeding the previously achieved maximum share value".
A worked example over four years
The example is not a real fund. It starts with $100 million and charges a 2% management fee on the value at the start of each year.
The performance fee is 20% of any gain above the high-water mark, after the management fee. Returns before fees are +20%, −10%, +10% and +10%.
Year | Return before fees | Management fee | Performance fee | Value at year end | High-water mark |
|---|---|---|---|---|---|
Start | $100.00 million | $100.00 million | |||
1 | +20% | $2.00 million | $3.60 million | $114.40 million | $114.40 million |
2 | −10% | $2.29 million | $0.00 million | $100.67 million | $114.40 million |
3 | +10% | $2.01 million | $0.00 million | $108.73 million | $114.40 million |
4 | +10% | $2.17 million | $0.61 million | $116.82 million | $116.82 million |
Total | $8.47 million | $4.21 million |
Source: YX Insights
In year 1 the fund gains 20%, taking $100 million to $120 million. The management fee is $2.00 million. The performance fee is 20% of the $18.00 million gain after that fee, or $3.60 million.
The fund ends year 1 at $114.40 million, which becomes the high-water mark.
In year 2 the fund loses 10% and falls to $102.96 million. It pays a $2.29 million management fee and no performance fee, ending at $100.67 million. The investor's return after fees is −12.0%.
In year 3 the fund gains 10% and pays a $2.01 million management fee, leaving $108.73 million. That is below the $114.40 million mark, so the performance fee is zero.
Without a high-water mark the fee would be 20% of the $8.06 million gain after the management fee, or $1.61 million.
In year 4 the fund gains 10% and pays a $2.17 million management fee, leaving $117.43 million. Only the $3.03 million above the mark counts, so the performance fee is $0.61 million. The fund ends at $116.82 million, the new mark.
Over the four years the fund paid $8.47 million in management fees and $4.21 million in performance fees, $12.68 million in all. With the same returns and no fees it would have reached $130.68 million. The investor's gain of $16.82 million is 55% of that $30.68 million.
How the mark held back the performance fee
Source: YX Insights
The chart shows the fund's value after fees at each year end, with the dashed line for the high-water mark. The value was below the mark at the end of years 2 and 3. It passed the mark only in year 4.
Years 3 and 4 had the same 10% return before fees. Year 3 paid no performance fee and year 4 paid $0.61 million, because only year 4 ended above the mark.
What the fees cost each year
Source: YX Insights
The chart splits each year's fees into the management fee and the performance fee. The management fee moves with the fund's value, from $2.29 million in year 2 to $2.01 million in year 3. The performance fee depends on the gain above the mark.
In year 1 the fees were $5.60 million, 28% of the $20.00 million gain before fees. The terms are our assumptions, so real funds will differ.
What the SEC data show on fees
Source: SEC Division of Economic and Risk Analysis (Form PF data); YX Insights
The chart plots the average hedge fund return before and after fees, estimated by SEC economists from Form PF. Form PF is the filing that SEC-registered advisers with at least $150 million in private fund assets generally must make.
The return after fees was lower in each of the 11 years from 2013 to 2023.
In 2018 a return of 0.4% before fees became −1.0% after fees. In 2022 SEC economists estimated total hedge fund fees and allocations at $38.8 billion. Allocations include fund and adviser expenses charged to the fund, so the total is wider than the two fees above.
The economists say the estimates may not reflect what any one investor paid, because share classes can carry different fees. They also dropped filings with errors, so the figures may not describe the whole industry.
Other terms in the fee contract
A hurdle rate is a minimum return the fund must beat before a performance fee applies. In an SEC example, a 10% hurdle, a 20% performance fee and a 25% return on $10,000 give a fee of $300. That is 20% of the 15 points above the hurdle.
Investor.gov says a performance fee could motivate a hedge fund manager to take greater risks. We compare these fees with other private funds in Hedge Fund vs Private Equity vs Venture Capital.
Multi-manager funds can also pass costs such as portfolio manager pay through to investors. We cover that in What Is a Multi-Manager Hedge Fund? The Pod Model
A high-water mark changes when the performance fee is charged. It does not change the management fee, which was $8.47 million of the $12.68 million paid in the example.
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Common questions about hedge fund fees
What does 2 and 20 mean in a hedge fund?
It is shorthand for a 2% yearly management fee on the fund's net assets and a 20% performance fee on its profit. Investor.gov gives typical ranges of 1% to 2% of NAV and 15% to 20% of profit, so 2 and 20 sits at the top of both ranges.
What is a high-water mark?
It is the highest value an investor's holding has reached. The fund can charge a performance fee only on gains above that value. A 2003 SEC staff report says the provision prohibits an adviser from collecting an incentive allocation twice for the same performance.
Do hedge funds charge fees when they lose money?
The management fee, yes, because it is a percentage of assets. In our four-year example the fund lost 10% in year 2 and still paid a $2.29 million management fee, with no performance fee. A performance fee is charged only on gains above the high-water mark.
What is a hurdle rate?
It is a minimum return the fund must beat before it can charge a performance fee. In an SEC example, a 10% hurdle, a 25% return on $10,000 and a 20% performance fee give a fee of $300. That is 20% of the 15 points above the hurdle.
DISCLAIMER: This article is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.