Hedge Fund

The standard arrangement pairs a management fee, charged as a percentage of assets under management, with an incentive fee, charged as a percentage of profits. Two critical details determine the arithmetic: whether the incentive fee is calculated on gains net of the management fee, and whether a hurdle rate must be cleared first. A hard hurdle pays the manager only on returns above the threshold; a soft hurdle pays on the entire gain once the threshold is passed.

A high-water mark prevents the investor from paying twice for the same performance. If a fund falls in value, no incentive fee accrues until the prior peak net asset value is recovered. Work an example in words: a fund begins the year at 100 and ends at 130 before fees. A two percent management fee on ending assets is 2.6. If the incentive fee of twenty percent applies to gains net of that fee, it is twenty percent of 27.4, or 5.48. Total fees of 8.08 leave the investor at 121.92, a net return under twenty-two percent against a gross twenty-two.9 percent.

Hedge fund strategies are conventionally grouped into four families. Equity hedge strategies trade equities long and short, including market neutral, short-biased and fundamental growth or value approaches; their returns reflect security selection plus residual factor exposure. Event-driven strategies target corporate actions such as mergers, restructurings and distressed situations, and effectively sell insurance against deal failure, producing frequent small gains punctuated by occasional large losses. Relative value strategies exploit pricing discrepancies between related instruments, typically convertible arbitrage or fixed-income arbitrage, and depend heavily on leverage because the underlying spreads are thin. Opportunistic strategies, principally global macro and managed futures, take directional positions across currencies, rates, commodities and indices, and are among the few groups with a plausible claim to genuine diversification during equity drawdowns.

Capital access is governed by contract rather than by an exchange. A lock-up period bars redemption for an initial term, a notice period requires advance warning before withdrawal, and redemptions are permitted only at stated intervals. A gate caps aggregate or per-investor withdrawals in any single period, and illiquid holdings may be moved into side pockets so that departing investors cannot force their sale. These provisions exist because the portfolio's liquidity must match its funding.

Operationally, most funds run through a master-feeder structure, with onshore and offshore feeders investing into a single master portfolio for tax efficiency. The prime broker provides financing, securities lending for short positions, custody and trade clearing. That relationship is the channel through which leverage arrives and, in stress, the channel through which margin calls force deleveraging.

Hedge fund indices are constructed from voluntary reporting, which introduces systematic distortions. Survivorship bias removes failed funds from the record, backfill bias allows a newly listed fund to add a favourable prior track record, and both push measured returns upward. Illiquid positions marked using model prices or stale quotes smooth reported returns, understating volatility and inflating correlation-based diversification claims.

Candidates should be able to identify these biases, compute net-of-fee returns under different hurdle and high-water-mark conventions, and explain why the Sharpe ratio flatters strategies with negatively skewed, fat-tailed return distributions. Downside-sensitive measures such as the Sortino ratio, maximum drawdown and value at risk provide a more informative picture, as does an assessment of leverage and redemption terms alongside the headline return.