Making Sense of Hedge-Fund Marketing

October 24th, 2013

Consider this: Members of the Securities and Exchange Commission (SEC) recently voted 4-1 in favor of allowing advertising for private investment vehicles.

This includes startups, other small companies looking to raise money, and yes, hedge funds. Previously, advertising for such private investments was prohibited by laws that go back 80 years. There are pros and cons to lifting the ban. Some think it will make it easier for small companies to raise money, expand, and create jobs. But there is also potential for fraudsters to exploit this marketing opportunity.

As of now, the SEC does not have a formal policy to define what’s okay and what’s not. It plans to keep a watchful eye on advertisements and to address investor protections in a separate public-comment process.

As we head into this new paradigm where hedge funds can advertise, here’s what you need to know to consider advertisements in proper context, so that you can make prudent investment choices.

Who Can Invest? Accredited Investors.

Hedge funds are still restricted to accredited investors. According to the law, you can qualify as an accredited investor if your net worth is greater than $1 million (not including your primary residence), or your annual income has been at least $200,000 in each of the past two years. According to the SEC, 7.4% of US households qualify. Theoretically, these criteria mean you understand the risks and can withstand a bad outcome. If you are an accredited investor, at the minimum, you should understand the fee structure, the lock-up, the use of leverage, and the risks of the investing strategy before you sign on the dotted line.

How do the fees work? Two & Twenty

Hedge funds usually charge their investors two types of fees – a base fee, calculated as a percentage of assets, and a profit incentive, calculated as a percentage of a fund’s increase in value. These fees vary, but commonly are about 2% of assets plus 20% of the increase, respectively.

Often these fees are assessed in quarterly installments, but let’s keep it simple for the purpose of illustrating how it works. Say you invest $200,000 in a hedge fund with a 2 & 20 fee structure. Over the course of a year, one investment gains total $50,000. The managers would end up collecting about $14,000 for that year, so your year-end balance would be $236,000 net of fees. Here’s an example:

The Math: Base & Incentive Fee

Initial Investment

$200,000

Investment Gains in Year One

$50,000

Total Before Fees

$200,000 + $50,000 =

$250,000

Base Fee

2% x $200,000 =

$4,000

Incentive Fee

20% x $50,000 =

$10,000

Total Fees

$4,000 + $10,000 =

$14,000

Total After Fees

$250,000 – $14,000 =

$236,000

Return Before Fees

($50,000 / $200,000) x 100% =

25%

Return After Fees

($36,000/$200,000) x 100% =

18%

So at first it may seem like your rock-star hedge-fund managers earned you a 25% return. After fees, however, your return amounts to 18%.

The 2 & 20 fee structure has its plusses and minuses. One obvious negative: $14,000 is a hefty fee when compared to a mutual fund (usually mutual-fund fees and expenses amount to about 2%, or $4,000 in this case) or passively investing in the S&P 500 index (which can cost as little as a fraction of a percent per year).

One positive: the profit incentive (the 20) clearly motivates the managers of the fund to achieve high returns. By contrast, mutual-fund managers are more focused on signing up new investors than investing the existing capital to achieve superior returns.

The key point here is: Always consider performance after fees. And make sure you understand how the fee structure works.

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