1. Legal and compliance costs – Hedge funds hire lawyers to assist them with the formation, management and compliance aspects of running the fund. Depending on their size and state (or states) where the fund operates and has significant commercial activity, hedge funds could be required to report to both state and federal administrative bodies. Additionally, some funds can have multiple entities, “sidecar” investments, offshore funds, or other complex structures which could drive up the legal costs of the fund. The more complex the fund, the higher the legal costs for that fund. Additionally, the larger the law firm that works with the fund, the higher the costs are likely to be as well.
3. Tax and audit costs – An annual third party audit is generally required of hedge funds, although the specifics can vary from fund to fund. The cost will depend on how many partners are in the fund, how many different brokerages the fund utilizes, the accuracy of the monthly accounting, and whether the auditor is experienced. Because the audit must be done by a third party, this independence requirement means that the bookkeeping and tax services must be done by a separate firm. Additionally, a hedge fund that trades frequently may have higher tax costs in the form of short term capital gains than a hedge fund that holds longer (though it will eventually have to pay tax on those gains once realized, albeit at a lower tax rate).
4. Operational costs – A hedge fund is a business. Depending on the size and structure of the fund, there may be security analysts employed, an HR department, other support staff and office space to pay for.
5. Technology costs – Technology costs in a hedge fund will vary depending on the strategy of the fund. For example, a hedge fund with an automated trading strategy that relies heavily on real-time data and research will have higher technology costs than a hedge fund with an investing strategy that makes only a few investments per year.
6. Marketing costs – Marketing costs in hedge funds vary widely both depending on the size, strategy and structure of the investment fund. For example, some hedge funds are not permitted to market at all. Other hedge funds may perform general solicitations of the public and will have higher marketing costs. Further, as all business owners know, there is never a shortage of marketing costs to the willing buyer and so these costs can vary widely.
7. Trading costs – Trading costs in hedge funds are another factor to consider. A fund that trades frequently will incur more trading commissions than a hedge fund that trades infrequently.
What drives costs down for hedge funds?
The number one factor that drives down costs for hedge funds is whether it is being run by a cheap operator! As most business owners know, there are costs associated with running a business and helping it grow, and a hedge fund is, of course, a business. However, a hedge fund that uses respected middle-market lawyers and accountants rather than “white shoe” lawyers and “Big Five” accountants is likely to have lower legal, administrative, tax, accounting and audit costs.
Additionally, a hedge fund with an active trading strategy and that subscribes to many research services is likely to have higher costs than a hedge fund that makes a few investments per year and does its own research. A Bloomberg terminal can cost up to $30,000 per year and is used by many hedge funds – but not all.
Why are some hedge funds so expensive?
The typical hedge fund fee structure consists of two fees. The “management fee” is an annual fee charged to the investor to cover the operating costs of the hedge fund, such as legal, compliance, administrative, salaries, office, marketing, travel, etc. Basically, all operating costs of the fund are charged to the investors in the fund. This fee is typically 2% of the assets under management (“AUM”) of the hedge fund and is paid regardless of the fund’s performance.
The “performance fee” is only charged when the fund’s profits exceed a prior agreed-upon level. This is typically 20% of profits. For example, if the agreed upon threshold is 8%, then the hedge fund may only charge the 20% performance fee if profits for the year surpass the 8% level.
Hedge funds that charge higher management fees are more expensive to its investors because those fees are paid regardless of the fund’s performance, whereas the performance fees are paid only once agreed upon profits are made for its investors.
Higher administrative fees can be a drag on investment returns over the long term: https://www.sec.gov/investor/alerts/ib_fees_expenses.pdf
Why are some hedge funds so cheap?
Some hedge funds charge fewer administrative fees to the investors in the fund. This is generally a decision made by the fund manager. The “original” hedge funds, which were Warren Buffett’s early partnerships in the 1950’s and 1960’s, did not charge a management fee to investors but did charge legal, tax and compliance fees. There are a few of these types of funds in the country which mirror the structure of the original Buffett partnerships. These funds also typically charge a 25% performance fee above a 6% hurdle.
Where does Oliva Partners fall in this range?
Oliva Partners does not charge a management fee but does charge legal, tax and compliance fees. This means that in the section titled “What drives costs up for hedge funds” above, investors are not charged for items 4, 5 and 6, while in other funds with a management fee of say 1 – 2%, you might be charged for these items. Additionally, Oliva Partners charges a 25% performance fee above a 6% hurdle.