Hedge fund returns are less transparent than those of traditional asset classes, such as stocks and bonds. The reason for this lies in the legal structure of the investment vehicle, which is organized as a limited partnership with the investment manager acting as general partner and the investors as limited partners. The contractual arrangement between these parties normally calls for a blend of fixed and performance-based fees, which must be taken into account to calculate the net investment return.
Identify the Hedge Fund's Fee Structure
Consult the hedge fund's investment prospectus to determine its fee structure. In most cases, the manager will charge a fixed management fee and a variable performance fee. For example, the management fee might be two percent of assets under management and the performance fee 20 percent of gains beyond returns in excess of a benchmark, such as the S&P 500 index. A hedge fund's fee structure is sometimes expressed in language such as "2 and 20," referring to the management and performance fees.
Calculate the Gross Return
Locate the hedge fund's net asset value in the fund's quarterly or annual investor communications. Select an investment period of interest, such as the one year period between January 1st and December 31st. Next, calculate the percentage increase in the the hedge fund's NAV between these dates. For example, if the NAV rose from $100 to $130 then the fund generated a gross return of 30 percent.
Calculate the Net Return
Deducted the fund's management and performance fees to calculate the net return. Suppose that an investor puts $100,000 into a fund with a "2 and 20" fee structure. Assume that the performance benchmark is the S&P 500, which returned 10 percent over the same period. In this case, the management fee equals $20,000 (2% x $100,000) and the performance fee $4,000 (20% x ((30% x $100,000) - (10% x $100,000). Thus, the investor is left with $106,000 after fees, or a net return of six percent ($106,000 / $100,000).
Adjust for the High Water Mark
Some hedge funds may stipulate a high water mark, or the NAV at which an investor buys into the fund. For example, if the investor buys the fund when its NAV is trading at $100 then this constitutes the high water mark. If the hedge fund loses money one year and recovers it the next investors aren't required to pay a performance fee on gains below the high water mark in the second year. Thus, if the NAV fell from $100 to $90 in first year and rebounded to $110 the second, an investor who put $100,000 into the fund would pay no performance fee the first year.
Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. He also founded GradSchoolHeaven.com, an online resource for graduate school applicants. He holds a Bachelor of Science in economics from the University of Pennsylvania, a Master of Arts in English from the University of Hawaii at Manoa, and a Master of Business Administration from Harvard University.