Is the nominal incentive fee charge by hedge funds (typically 20% of profits exceeding a previous high-water mark) representative of the actual aggregate incentive fee paid by fund investors? In the July 2020 revision of their paper entitled “The Performance of Hedge Fund Performance Fees”, Itzhak Ben-David, Justin Birru and Andrea Rossi (1) quantify the actual aggregate incentive fee paid by investors across a large sample of hedge funds over a 22-year sample period and (2) explore reasons for the difference between actual aggregate and nominal fees. Using return and management/performance fee data for 5,917 live and dead hedge funds during 1995 through 2016, they find that:
- Over the full sample, the aggregate management fee is 1.51% of aggregate assets under management (AUM) annually, while the aggregate incentive fee is an additional 1.93% of AUM.
- Framed differently, investors receive only 36% of gross hedge fund profits in excess of high-water marks, with the other 64% going to management and incentive fees.
- Results translate to an aggregate effective incentive fee rate 49.6%, 2.5 times the average nominal 19%.
- The main reasons that the aggregate effective incentive fee rate is so much higher than average nominal are:
- Investors cannot offset gains and losses across funds, adding about 15% to the nominal rate. This inability to offset incentivizes fund managers to offer multiple funds with narrow strategies in hopes of accruing some incentive fees under all market conditions.
- Investors tend to withdraw money and managers tend to close funds after losses, thereby both eroding the protection of high-water marks and adding 8.4% and 5.4%, respectively, to the nominal rate.
In summary, asymmetry of incentive fee terms, investor return-chasing and closures of underperforming funds make the actual aggregate hedge fund incentive fee about 2.5 times the average nominal rate.
Cautions regarding findings include:
- Findings are aggregate. Individual hedge fund investors have widely differing experiences.
- Because hedge fund performances are not fully transparent, the authors use modeling assumptions/simplifications.
- The study focuses on gross and net returns in excess of high-water marks, not total returns.
