CFA Level IAlternative InvestmentsMedium
A hedge fund charges a 2% annual management fee (based on beginning-of-year NAV) and a 20% incentive fee on profits after the management fee, with no hurdle rate. At the start of the year, an investor's capital is $10,000,000, and the fund earns a 15% gross return before fees. What is the investor's net dollar profit after all fees?
- A$1,040,000
- B$900,000
- C$1,300,000
- D$1,200,000
Show answer & explanationAnswer & explanation
Correct answer: A. $1,040,000
Gross profit = $10,000,000 × 15% = $1,500,000. Management fee = $10,000,000 × 2% = $200,000. Profit after management fee = $1,500,000 − $200,000 = $1,300,000. Incentive fee = 20% × $1,300,000 = $260,000. Net profit = $1,500,000 − $200,000 − $260,000 = $1,040,000.
Why the other options are wrong
- B. Incorrectly applies the incentive fee on gross profit before deducting the management fee, then over-subtracts.
- C. Only subtracts the management fee, omitting the incentive fee.
- D. Ignores the incentive fee entirely.
Hedge Fund Fee Structure
Hedge funds typically charge a management fee (percentage of AUM) plus an incentive fee (percentage of profits), often stacked so the incentive fee is calculated on profit after the management fee is deducted.
- Management fee is usually charged regardless of performance
- Incentive fee is typically 15–20% of profits
- Order of fee calculation (before/after management fee) affects investor returns
Memory trick: Manage first, then reward the win — fees stack before the incentive fee begins.