Question

8. A hedge fund charges 2% plus 20%. A pension fund invests in the hedge fund. Plot the return to the pension fund as a function of the return to the hedge fund. The incentive fee of 20% is charged on the return after subtracting the annual 2%. No incentive fee is charged if the return after subtracting the annual 2% fee is negative. [hint: Probably best if you do this in Excel, however, you could also use grid paper to create a nice, high quality graph by hand.]

Answer 1

The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management

The 2 and 20 fee structure helps hedge funds finance their operations. The 2% flat rate charged on total assets under management (AUM) is used to pay staff salaries, administrative and office expenses, and other operational expenses.

The 20% performance fee is the biggest source of income for hedge funds. The performance fee is only charged when the fund’s profits exceed a prior agreed-upon level. A common threshold level used is 8%. That means that the hedge fund only charges the 20% performance fee if profits for the year surpass the 8% level.

For example, assume a fund with an 8% threshold level generates a return of 15% for the year. Then the 20% performance fee will be charged on the incremental 7% profit above the 8% threshold. If the hedge fund manages assets of 10 large investors and makes a sizeable profit, its income for the year may run into millions – sometimes billions – of dollars.