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Hedge-Fund Bargains? In Some Cases, Yes

Hedge funds that are 'underwater' can be attractive for investors because of lower fees.

NEW YORK (TheStreet) -- Hedge funds are famous for charging steep fees.

But the pickings have been slim lately because money-losing funds are what's known as underwater, a condition that erodes fees. Revenues have been so low that many funds have been forced to close their doors.

"In 2009 and into this year, tons of funds shut down because they were underwater," says Howard Kapiloff, managing editor of Hedge Fund Alert, a newsletter.

The problem stems from the peculiar way that hedge funds are compensated. The typical fund charges an annual expense ratio of 2% of assets plus a performance fee that equals 20% of profits. To make sure fund managers focus on delivering gains, the performance fees are only paid when the portfolio reaches a new high -- a point that is known as the high-water mark.

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Say you invested $1 million into a hedge fund at the beginning of 2008, and by the end of the year your stake had fallen to $800,000. You would be underwater, and the fund manager would receive no performance fee for the year. Now suppose the fund gained in 2009, and your holding recovered to $1 million. The fund would still get no performance fee because it was rising back to the old high-water mark. If your stake climbs above $1 million this year, the fund sets a new high-water mark, and the managers can take 20% of the gains.

In a good year, funds can set new high-water marks and collect huge performance fees. But since the credit crisis began, many funds have fallen short of their targets. In 2008, a big percentage of hedge funds failed to reach their high-water marks. Although the markets recovered in 2009, many funds remain underwater. For the 12 months ending in June this year, 43% of funds failed to reach their high-water marks, according to Hedgefund.net, an industry tracker.

Unable to collect performance fees for two years in a row, many funds are in trouble. The problem is particularly bad for small funds. Say a fund has $100 million in assets and charges 2% annual management fees. The $2 million in annual income may be enough to keep the lights on, but the revenues cannot cover big salaries. Tired of not receiving bonuses, talented portfolio managers may jump to funds that are above water.

In many cases, underwater funds simply shut down and return money to investors. The portfolio managers soon open another fund that can make a fresh start. "If you have two bad years in a row, the staff is likely to bolt," says Howard Kapiloff.

If you are an investor in a fund that is underwater, should you cash out and switch to a choice that has just set a new high-water mark? Not necessarily. Because of the way performance fees are calculated, underwater funds can be bargains.

Say you invest $1 million in a brand-new fund, and the fund gains 10% in the first year. You will have $1.1 million, but the fund will take 20% of the profits, or $20,000. If you enjoyed the same gain in an underwater fund, you would owe no performance fees.

Investors who are comparing the return records of funds should pay special attention to the impact of performance fees, says Thomas Kirchner, manager of

Quaker Event Arbitrage Fund

(QEAAX)

, a mutual fund. To calculate the total return of a hedge fund, the fees are subtracted from gross returns. As a result, a startup fund that earns performance fees will be handicapped when it is compared to an underwater fund with no fees. "When funds are underwater, the performance records are distorted," says Kirchner.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.