A Fee Frenzy At Hedge Funds

As investors pile in, managers are tacking on extra fees

Anyone who knows anything about hedge funds is aware that these private investment pools don't come cheaply. But the typical management fees of 1% to 2% of net assets -- plus 20% of the profits -- are often only part of the total tab. Add in extra charges for items such as audits, account administration, and trader bonuses, and the average hedge-fund investor pays as much as 3.5% of assets a year, according to a recent study by LJH Global Investments, a Naples (Fla.) adviser to hedge-fund investors.

Some hedge funds have been charging investors for those costs all along. But others may be taking expenses once bundled into the management fee and making them add-ons, without lowering the management fee. "This is happening more and more," says Michael Hennessy, managing director at Morgan Creek Capital Management, a Chapel Hill (N.C.) money manager. "Investors are throwing money at hedge funds, so the managers have a lot of power right now."

Fees and expenses didn't seem so onerous when hedge funds were riding high. From Jan. 1, 1990, through the end of April, 2005, hedge funds returned an average of 11.6% a year after fees, vs. 10.4% for the Standard & Poor's (MHP ) 500-stock index. But that longer-term average masks a recent period of weaker returns. In the 16 months ended on Apr. 30, hedge funds beat the S&P 500 only by a scant 0.2% on an annualized basis, according to Ryan Meredith, senior research analyst at Citigroup (C ) Alternative Investments.

The likely reason for the decline: Too many funds with too much money are chasing too few opportunities. Since 2000, the number of funds has more than doubled, to an estimated 8,050, while assets have almost tripled, to nearly $1 trillion. As funds struggle for returns, costs will have an even bigger impact on investor returns.


How can you find the costs of these often-secretive investments? Ask the hedge fund for its private placement memorandum or partnership agreement. You will have to show that you qualify as an investor. (Typically your net worth must exceed at least $1 million.) These documents generally identify the costs of running the fund and spell out which are covered by the management fee and which are billed as extra expenses. But they won't necessarily quantify the charges. With funds-of-funds, which are managed portfolios made up of hedge funds, you can also check the Securities & Exchange Commission's Web site (sec.gov). Dozens of funds are registered with the agency so they can be marketed to a larger number of investors. Several are available with an initial investment of just $25,000 -- a fraction of the more common $1 million minimum.

Hedge funds don't have a standard fee structure. The extra expenses a hedge fund passes along generally cover administrative and professional services, such as audits and accounting. For such items, you should expect to pay up to 0.5% extra, says James Hedges IV, president of LJH. But a recent LJH study of about 100 hedge funds showed that many pass along other expenses as well, including trader bonuses, technology spending, and the undefined catch-all, "other." In 2003, the latest year for which data are available, the average hedge fund's bill for extras was 1.95% of net assets -- an amount that when added to the average 1.5% management fee brings the total annual tab to nearly 3.5%, before the fund's cut of the profits.

At some hedge funds, expenses can comprise a big chunk of the overall cost of investing. In 2003, for instance, Amaranth Advisors of Greenwich, Conn., logged charges on its Amaranth Partners fund of about 1.4% of net assets for "bonus compensation to designated traders" and about 2.3% for "operating expenses." Although Amaranth does not have a traditional management fee, the filing reveals that when an investor's account shows a net profit over the previous 12 months, the manager is entitled to a "management allocation of income" of up to 1.5% of each member's account balance per year. The manager also receives a 20% cut of each investor's net profits. This 20% is reduced by the amount paid to the traders, as well as by the amount of the operating expenses. If the fund is losing money, investors remain on the hook -- certainly for the operating expenses and possibly for any trader bonuses, too. Amaranth declined to comment.

Because hedge funds are not required to make public disclosures, BusinessWeek obtained 2003 financial statements -- the most recent available -- for funds through a Freedom of Information Act request from the Commodity Futures Trading Commission, which regulates hedge funds that invest in commodities futures contracts. Although hedge funds are not required to disclose financial statements, most do to their current investors.

Just because a hedge fund charges above-average management and performance fees doesn't mean it spares investors extra expenses. For example, the Tudor BVI Global Portfolio, with a 25% average annual return since its 1986 inception, levies a fat 4% management fee and swallows 23% of the profits. But it takes an extra fee of about 0.09% for administrative and other expenses, too. Tudor declined to comment.


The costs get even higher for funds-of-funds. For instance, Merrill Lynch's (MER ) recently launched Multi-Strategy Hedge Opportunities fund has a management fee of 1.5%. Administrative costs, member services, and other charges push the projected total tab for asset-based fees to about 3% a year (table). But that's not all. As is the case with most funds-of-funds, investors bear the costs of the hedge funds the portfolio invests in -- each of which charges up to 3% in asset-based fees per year, plus 15% to 25% of profits. There's also a 3% maximum sales charge. A Merrill spokeswoman says the fund's administrative, member services, and other expenses will decrease as the fund's assets grow.

Don't think you can negotiate fees. If you don't like the fund's terms, someone else will take your place. "Capacity is ridiculously tight," says Timothy Jackson, a partner at hedge-fund consultant Rocaton Investment Advisors in Norwalk, Conn. "We have to work very hard to get clients into the funds we recommend." All you can do is make sure you understand all the fees -- and decide whether it's still worthwhile to invest in the funds.

By Anne Tergesen

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