Question

1. You invested $1,250,000 with a market-neutral hedge fund manager. The fee structure is 2/20, and the fund has a high-water mark provision. Suppose the first year the fund manager loses 5 percent, the second year she gains 13 percent, and the third year she gains 7 percent. Assume management fees are paid at the beginning of each year and performance fees are taken at the end of each year.

What are the management and performance fees paid each year?

Answer 1

Year 1

Management fees = 1,250,000 × 2% = $25,000

No performance fees as it makes a loss

AUM (After loss and Management) = 1,250,000 - 25,000 - (5% × 1,250,000 - 25,000)

= 1,250,000 - 25,000 - 61,250

= 1,163,750

Year 2

Management fees = 2% (1,250,000 - 25,000 - 61,250)

= 2% (1,163,750)

= $23,275

High watermark = 1,250,000

Performance fees is 20% of anything above watermark.

(1,163,750 - 23,275) × (1+0.13) = 1,288,736.75
(1,288,736.75 - 1,250,000) × .20 = $7,747.35

Year 3

In year 3, AUM = 1,288,736.75 - 7,747.35

= 1,280,989.40

Management fees= AUM × 2%

= 1,280,989.40 × 2%

= $25,619.79

New watermark = 1,288,736.75

performance fees is 20% of anything above new watermark

(1,280,989.40 - 25,619.79) (1+0.07) = 1,343,245.48

(1,343,245.48 - 1,288,736.75) × 20% = $10,901.75

All the answers are in bold