Hedge funds have become popular investments for those with high enough net worth or income to qualify as accredited investors. Yet although hedge funds promise the potential for market-beating returns, they also come with a fee structure that many investors haven't experienced elsewhere. In particular, the performance-based incentives that hedge funds offer their managers can have a dramatic impact on your net return.

Simple hedge fund returns
Figuring out a hedge fund's return prior to paying fees is typically fairly simple. Take the ending balance of your hedge fund account before it imposes its fees and divide it by the balance that you had at the beginning of the period. Subtract 1 and then multiply by 100, and the result gives you your percentage gross return from your hedge fund investment.

That's similar to how you would calculate gross returns for any investment. Where things get tricky is taking fees into account.

The complexity of net returns on hedge funds
The challenge with hedge fund fees is that they typically come with two components. Most hedge funds charge a fixed fee based on a percentage of assets under management, and 2% annually is a typical figure. In addition, hedge funds also charge an incentive-based management fee, which is calculated as a percentage of profits above a certain benchmark return. A typical arrangement is to take 20% of all returns in excess of 5%.

To make things clearer, consider an example. Say that you invest $1 million in a hedge fund, and at the end of a year, your account is worth $1.2 million. Your simple gross return is $1.2 million divided by $1 million, or 1.2, minus 1. That gives you 0.2, which works out to 20%.

However, your net return will be much less. If the fund charges a 2% fixed fee, then you'll pay $24,000 in fees at the end of the year. For the incentive fee, your account went up in value by $200,000, but the 5% benchmark rate means that you don't have to pay the fee on $50,000 of it. An incentive of $150,000 multiplied by 20% adds another $30,000 to the total cost of the hedge fund. Subtract both fees, and you're left with a final net account balance of $1.146 million. That corresponds to a net return of 14.6%.

Note that the net return is substantially less than the gross return -- more than five percentage points less in our example. That reflects the importance of understanding fee structures. Many hedge funds take huge fees that have a dramatic downward impact on investor returns.

Hedge funds have become popular because investors hope for big successes. Yet you have to be prepared for the fund managers to take a large cut, and if you don't account for a substantial drain on your net return, you'll end up disappointed.

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