Hedge Fund Compensation Structure

Primarily, hedge funds adhere to a compensation structure with two essential layers. This formula includes a 2 percent charge for the investment talent running the fund. This is known as a management fee. Investors are also charged a 20 percent fee for the investment performance of the fund. Hedge fund managers must continue to improve a fund's performance, or sacrifice the performance fee. There are ways, however, for a fund manager to recapture lost performance fees.

Hedge funds typically assess a 2 percent management fee to pay for trading expenses and other logistical costs. The percentage is tied to the amount of capital that an investor has under management at a particular fund. This modest layer of fees is designed to attract a greater number of investors to the fund. However, funds could grow so large that the portfolio size interferes with a professional manager's ability to successfully run the fund. Subsequently, certain funds eventually stop accepting new investors.

Much of a hedge fund's compensation structure is tied to the investment performance of the fund. Fund managers assess a performance fee of approximately 20 percent of returns earned for investors. To avoid charging investors more than once for the same returns, hedge funds do not charge performance fees when an investment fund loses ground. Once the fund surpasses the highest point it previously achieved, which is known as a high water mark, performance fees can once again be charged.

Bonuses at the end are not a sure thing for hedge fund managers. Less than 20 percent of hedge fund managers are assured a year-end bonus, according to the Hedge Fund Compensation Report cited on PR Web. Of those who are entitled to a yearly bonus, more than 10 percent reinvest at least a portion of those earnings back into the hedge fund. Hedge funds can use this practice as a motivational tool so portfolio managers have an even more vested interest in the fund's performance.

Investors do not always feel that the high compensation structure at hedge funds is warranted. When the markets are clearly moving in one direction, for instance, the argument for paying high fees to hedge fund managers weakens. Market volatility, however, increases the value of professional hedge fund managers who are trained to navigate choppy market waters. In the first eight months of 2011, hedge funds returned approximately 3 percent, which is modest. Given that losses unfolded in the broader stock market over the same period, hedge funds won over investors despite high fees.