Hedge Funds: Structures

Structurally, a hedge fund has some similarities to a mutual fund. For example, just like a mutual fund, a hedge fund is a pooled investment vehicle that makes investments in equities, bonds, options and a variety of other securities. It can also be run by a separate manager, much like a sub-advisor runs a mutual fund that is distributed by a large mutual fund company. That, however, is basically where the similarities end. The range of investment strategies available to hedge funds and the types of positions they can take are quite broad and in many cases, very complex. We will focus on specific strategies later in this tutorial, so for now we'll focus on how hedge funds are structured.

Fee StructureHedge funds also differ quite radically from mutual funds in how they charge fees. Their fee structure is one of the main reasons why talented money managers decide to open their own hedge funds to begin with. Not only are the fees paid by investors higher than they are for mutual funds, they include some additional fees that mutual funds don't even charge.

Incentive Fee
Most if not all hedge funds charge an incentive fee of anywhere between 10-20% of fund profits, and some hedge funds have even gone as high as 50%. The idea of the incentive fee is to reward the hedge fund manager for good performance, and if the fund's performance is attractive enough, investors are willing to pay this fee. For example, if a hedge fund manager generates a 20% return per year, after management fee, the hedge fund manager will collect 4% of those profits, leaving the investor with a 16% net return. In many cases, this is an attractive return despite the high incentive fee, but with more mediocre managers entering the industry in search of fortune, investors have more often than not been disappointed with net returns on many funds.

Management Fee
The management fee for a hedge fund is for the same service that the management fee covers in mutual funds. The difference is that hedge funds typically charge a management fee of 2% of assets managed – and in some cases even higher, if the manager is in high demand and has had a very good track record. This fee alone makes managing a hedge fund attractive, but it is the next fee that really makes it a profitable endeavor for good fund managers.

Hedge funds often follow the so-called "two and twenty" structure – where managers receive 2% of net asset value managed and 20% of profits, though as mentioned, these fees can vary among hedge funds.

Organizational Structure
The typical hedge fund structure is really a two-tiered organization.

Figure 1: Hedge Fund Organizational Structure

The general/limited partnership model is the most common structure for the pool of investment funds that make up a hedge fund. In this structure, the general partner assumes responsibility for the operations of the fund, while limited partners can make investments into the partnership and are liable only for their paid-in amounts. As a rule, a general/limited partnership must have at least one GP and one LP, but can have multiple GPs and many LPs. There is an SEC rule, however, that generally limits investors to 99 in order to be excluded from SEC registration.