How do hedge fund fee structures work, and what is the high-water mark provision?
I'm confused about hedge fund fees for CFA Level I. I know they charge '2 and 20' but what happens after a losing year? Does the fund still charge performance fees? And what exactly is a high-water mark vs. a hurdle rate?
Hedge fund fee structures are more complex than mutual fund fees and are a frequently tested topic. Let's walk through the mechanics.
Standard Fee Structure (2 and 20):
- Management fee: 2% of assets under management (AUM), charged regardless of performance
- Incentive fee (performance fee): 20% of profits above a benchmark or hurdle
High-Water Mark (HWM):
The high-water mark is the highest previous NAV that the fund achieved. The fund can only charge incentive fees on new profits above the high-water mark.
Example — Crestfield Global Macro Fund:
Starting AUM: $500 million
Year 1: Fund returns +15%
- Ending NAV (before fees): $575M
- Management fee: 2% x $500M = $10M
- Incentive fee: 20% x ($575M - $500M) = 20% x $75M = $15M
- NAV after fees: $575M - $10M - $15M = $550M
- New high-water mark: $550M
Year 2: Fund returns -10%
- Ending NAV (before fees): $550M x 0.90 = $495M
- Management fee: 2% x $550M = $11M
- Incentive fee: $0 (NAV below high-water mark)
- NAV after fees: $495M - $11M = $484M
- High-water mark remains: $550M
Year 3: Fund returns +20%
- Ending NAV (before fees): $484M x 1.20 = $580.8M
- Management fee: 2% x $484M = $9.68M
- Incentive fee: Only on gains above HWM: 20% x ($580.8M - $550M) = 20% x $30.8M = $6.16M
- NAV after fees: $580.8M - $9.68M - $6.16M = $564.96M
- New high-water mark: $564.96M
Key Observation: In Year 3, even though the fund gained 20% ($96.8M), the incentive fee is only calculated on the $30.8M above the high-water mark, not the full gain. The HWM protects investors from paying performance fees on recovered losses.
Hurdle Rate vs. High-Water Mark:
| Feature | Hurdle Rate | High-Water Mark |
|---|---|---|
| Purpose | Minimum return before incentive fees | Prevents fees on loss recovery |
| Basis | Fixed rate (e.g., SOFR + 2%) | Previous peak NAV |
| Soft hurdle | Incentive fee on ALL gains once hurdle is exceeded | N/A |
| Hard hurdle | Incentive fee only on gains ABOVE the hurdle | N/A |
Exam tip: CFA Level I loves multi-year fee calculation problems. Always track the high-water mark year by year. Remember: management fees are charged regardless of performance, but incentive fees require both positive returns AND exceeding the high-water mark.
For more hedge fund content, check our CFA Level I alternatives module on AcadiFi.
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