Level 1 CFA® Exam:
Performance Calculation
In this lesson, we’re going to learn how to calculate net-of-fees returns on alternative investments.
The fee associated with hedge fund investments is made up of 2 components:
- a management fee whose value is usually independent of investment performance, and
- an incentive fee (also called performance fee) associated with the performance of the fund and its management.
What should you know about the fees?
- The management fee may be calculated based on the value of assets at the beginning or at the end of the valuation period.
- Whether or not an incentive fee is charged depends on whether the rate of return on the fund reaches the so-called hurdle rate. The hurdle rate can be determined as a fixed percentage or a variable value depending on, for example, LIBOR.
- There are two types of hurdle rate, namely a hard hurdle rate and a soft hurdle rate. A soft hurdle rate is when a catch-up clause is included.
A hard hurdle rate means that the incentive fee is calculated only on the returns above the hurdle rate, while a soft hurdle rate (with a catch-up clause) means that the incentive fee is calculated on the total return but only when the achieved rate of return is at least at the level of the hurdle rate.
In addition, a fund's fee structure may define the so-called high water mark. The high water mark is a parameter that specifies that the incentive fee is not calculated for profits that cover losses from previous periods.
What else do you need to know about the calculation of net profit?
It is extremely important to know whether fees for a given fund are calculated independently or whether the incentive fee is calculated only after the management fee has been taken into account.
So in your CFA exam, when calculating the net return for someone who invests in a hedge fund, you should pay attention to 4 things:
- The amount based on which the management fee is calculated – you should know whether this amount is the value of assets at the beginning or at the end of the year.
- In the case of an incentive fee, you should know whether and how the hurdle rate is calculated.
- You should also know whether the management fees and incentive fees are calculated independently or if the incentive fees are calculated based on the profit net of the management fee.
- You should also know whether a high water mark is specified or not.
The initial value of the Extreme Heights Fund assets is USD 100 million. The management fee was set at 2% and is calculated based on the value of the assets at the end of the year. The incentive fee is 20%. In the first year, the fund’s return on investment was 36%. What is the amount of the net return if the fees are calculated independently of each other?
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The initial value of the Extreme Heights Fund assets is USD 100 million. The management fee was set at 2% and is calculated based on the value of the assets at the end of the year. The incentive fee is 20%. In the first year, the fund’s return on investment was 36%. What is the amount of the net return if the incentive fee is calculated from the return net of the management fee?
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The initial value of the Extreme Money Fund assets is USD 100 million. The management fee was set at 2% and is calculated based on the value of the assets at the beginning of the year. The incentive fee is 20%. In the first year, the fund’s return on investment was 36%. What is the net profit if the incentive fee is calculated after the management fee has been subtracted and the hard hurdle rate is at the level of 7%?
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The initial value of the Extreme Money Fund assets is USD 100 million. The management fee was set at 2% and is calculated based on the value of the assets at the beginning of the year. The incentive fee is 20%. In the first year, the fund’s return on investment was 36%. What is the net profit if the incentive fee is calculated after the management fee has been subtracted and the soft hurdle rate with a catch-up clause is at the level of 7%?
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Evaluating the financial performance of hedge funds involves many difficulties. They are mostly a consequence of the absence of disclosure obligations. Only some hedge funds make their financial details publicly available. Databases and indices evaluating the performance of individual hedge funds are based on this limited information. Another problem is the lack of clear criteria for creating such databases or indices.
This is why methods of evaluating the financial performance of hedge funds significantly differ from one another. Some databases are based on equal weights for each fund. Others classify funds by size and assign the weights on that basis. All this translates into errors that distort the results of hedge fund performance analyses.
Let's take a closer look at problems with measuring and presenting historical returns based on hedge fund indices. We can name two basic types of biases that affect the performance of hedge fund indices:
- survivorship bias, and
- backfill bias.
According to the survivorship bias we include only active funds, that is the funds that still exist, while those funds that are no longer present on the market are not analyzed. So, the rates of return are artificially high because unsuccessful or liquidated funds are not considered.
Backfill bias concerns a situation when only funds with good track records enter the database. It often happens that hedge funds report records of their rates of return only when the returns are higher than those of their competitors. Therefore, the performance of less successful funds may not be taken into consideration in a particular index. Consequently, just as in the case of survivorship bias, we deal with unnaturally high rates of return.
The two biases that we mentioned above are not the only threats linked to the measurement and presentation of data on historical returns of hedge fund indices. For example, we should take notice of the index construction. Some funds in the index may be overweight and some – underweight. It may lead to the unreliable reported performance of the funds.
- The fee associated with hedge fund investments is made up of 2 components: a management fee whose value is usually independent of investment performance and an incentive fee (also called performance fee) associated with the performance of the fund and its management.
- The management fee may be calculated based on the value of assets at the beginning or at the end of the valuation period.
- Whether or not an incentive fee is charged depends on whether the rate of return on the fund reaches the so-called hurdle rate.
- There are 2 types of hurdle rate: a hard hurdle rate and a soft hurdle rate.
- A soft hurdle rate is when a catch-up clause is included.
- According to the survivorship bias we include only active funds, that is the funds that still exist, while those funds that are no longer present on the market are not analyzed.
- Backfill bias concerns a situation when only funds with good track records enter the database.