Hedge Fund Return Calculation

Hedge fund return calculation can be more complex compared to traditional investment vehicles due to the diversity of strategies employed by hedge funds. The two common methods used to calculate hedge fund returns are the Time-Weighted Return (TWR) and the Money-Weighted Return (MWR). The TWR considers the performance of the fund over specific time intervals, independent of cash flows. On the other hand, the MWR accounts for the impact of cash flows, such as contributions and withdrawals, which can significantly influence the overall return experienced by individual investors.

For example, consider a hedge fund that generated a 5% return in the first quarter and 7% in the second quarter. If an investor contributed additional capital to the fund at the beginning of the second quarter, the TWR would be used to assess the fund’s performance for each quarter. However, if another investor joined the fund and made a large contribution just before the second-quarter performance, the MWR would be more relevant to evaluate the return experienced by that specific investor.

Incentive Fee Structure of Hedge Funds

Hedge funds commonly employ a performance-based fee structure, known as the incentive fee, which differentiates them from traditional mutual funds. The incentive fee is calculated based on the fund’s performance, and it is typically a percentage of the fund’s profits. It incentivizes hedge fund managers to generate higher returns since they stand to benefit directly from their successful investment decisions.

For instance, a hedge fund might have an incentive fee of 20% of the fund’s profits. If the fund generates a positive return of 15% during a specific period, the incentive fee would be calculated as 20% of the 15% return, resulting in a fee of 3%. The remaining 12% would be retained by the fund’s investors.

Hurdle Rate, High-Water Mark, and Clawback

Hedge funds often impose additional performance conditions on their incentive fee structure to align the interests of fund managers and investors. These conditions are commonly known as the hurdle rate, high-water mark, and clawback.

Hurdle Rate

The hurdle rate is a predetermined minimum return that a hedge fund must achieve before the incentive fee is applied. It protects investors from paying performance fees if the fund’s return falls below the agreed-upon hurdle rate. For example, if the hurdle rate is set at 5% and the fund generates a return of 3%, no incentive fee would be charged to investors.

High-Water Mark

The high-water mark ensures that the hedge fund manager only receives incentive fees on new profits, not on previously earned returns that have declined. It means that the fund’s net asset value (NAV) must exceed the highest historical NAV achieved before any new incentive fees can be charged.

Clawback

The clawback provision is a risk-mitigating mechanism that allows investors to recoup previously paid incentive fees if the fund’s performance subsequently declines. If the fund experiences losses after paying incentive fees, the manager may be required to reimburse the fund for the excess fees received in previous periods.