Investments, tenth edition

 Example  26.3 

Tail Events and Long-Term Capital Management 

 However,  Figure  26.6  shows that the broad hedge fund index did not exhibit notice-

ably greater tail risk than other stock investments during the financial crisis of 2008–2009. 

While equity returns were generally dismal in that period, typical hedge fund returns were 

actually less negative than those of the S&P 500. This, of course, is consistent with the 

generally low betas of these funds.    

 The typical hedge fund fee structure is a management fee of 1% to 2% of assets plus an 

   incentive  fee    equal to 20% of investment profits beyond a stipulated benchmark perfor-

mance, annually. Incentive fees are effectively call options on the portfolio with a strike 

price equal to current portfolio value times 1  1  benchmark return. The manager gets the 

fee if the portfolio value rises sufficiently, but loses nothing if it falls.  Figure 26.7  illustrates 

the incentive fee for a fund with a 20% incentive fee and a hurdle rate equal to the money mar-

ket rate,  r  

 f 

  . The current value of the portfolio is denoted  S  

0

  and the year-end value is  S  

 T 

 .  The 

incentive fee is equivalent to .20 call options on the portfolio with exercise price  S  

0

 (1  1   r  

 f 

   ).   

    26.6 

Fee Structure in Hedge Funds  

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P A R T   V I I

  Applied Portfolio Management

 Suppose the standard deviation of a hedge fund’s annual rate of return is 30% and the 

incentive fee is 20% of any investment return over the risk-free money market rate. If 

the portfolio currently has a net asset value of $100 per share, and the effective annual 

risk-free rate is 5% (or 4.88% expressed as a continuously compounded rate), then 

the implicit exercise price on the incentive fee is $105. The Black-Scholes value of a call 

option with  S  

0

   5  100,  X   5  105,  s   5  .30,  r   5  .0488,  T   5  1 year is $11.92, just a shade 

below 12% of net asset value. Because the incentive fee is worth 20% of the call option, 

its value is just about 2.4% of net asset value. Together with a typical management fee 

of 2% of net asset value, the investor in the fund pays fees with a total value of 4.4%.