Do You Know What You're Paying your Hedge Fund Manager?

The Federal K-1 tax forms are now reaching investors for their share of the profit or loss in their hedge fund investments. Most investors will mail their K-1 to their CPA and head out for a round of golf, none the worse for the experience. They know they pay the 2% management fee and the 20% incentive performance fee to the fund manager, but a sinister, stealth form of compensation may also be reaching the back pocket of the fund manager.

Due to the sheer volume of trading, fund managers negotiate very low commission rates; say $2 per equity trade or 25 cents per futures contract, with the clearing firm. The clearing firm may then charge the hedge fund $5 per trade or futures contract, and then rebate the difference directly to the hedge fund manager. At first glance, you might say to yourself, "it's only about $4 a trade, what's the big deal"? But, in reality, the hedge fund may trade 5-10 thousand contracts per day. That amounts to $40,000 per day, or $8 million per year in stealth compensation to the hedge fund manager. Do you think that $8 million in excess commissions might effect the overall performance numbers of the hedge fund?

This compensation may even dwarf the management and incentive fees paid to the manager. Why do I call these types of soft compensation "stealth”? First, if it is disclosed in the hedge fund offering, it is likely in the small print, the very small print. Second, it's not likely to be separately stated on the monthly or quarterly statements sent to investors. Third, since the managers share of the total commissions charged by the clearing firm are not separately stated on the monthly trading statement, they would likely go unquestioned and undetected by the fund administrators and the outside auditors.

So, if it's hard for administrators and auditors to detect it, how can the investor detect it? First, they can ask the fund manager if the condition exists. Or, they can ask the fund manager for a monthly statement and if commissions exceed the above amounts, there may be a problem. Or, you may receive the telltale letter from the fund manager with your periodic statement, wherein they inform you they will forego the management fee this quarter because performance is below expectations (I guess $40,000 per day in soft commissions gave them a guilt trip?).

I can only speculate on how those excess commissions are used. They may be used for the corporate condo in St. Kitts or a luxury yacht, or they may be used to grease the palms of investment advisors to keep those investors flowing in. They may be used to pay off union, public school or government pension administrators as a reward for investing in the fund, or it may just be hidden away in the Caymans or the British Virgin Islands outside of the grab of the IRS. But, in the end, the amount of compensation investor’s pay to the fund manager is the responsibility of the investor. So, if the performance of the fund is less that what you've been promised or expect, take some time to find out why.