The Hurdle Rates Debate In The Hedge Fund Industry

The Hurdle Rates Debate In The Hedge Fund Industry

Hurdle rates are the lowest rates that an investor or a fund manager deem acceptable. Part of the hurdle rates debate stems from the fact that the fund managers make their money through performance fees when the investments do well, but they don’t pay a penalty when the investments do poorly. Meanwhile, the investors do make money when the investments do well, but they also lose their proverbial shirts when they do poorly. A further problem is that both the Investment Advisers Act of 1940 and the Employee Retirement Income Security Act, though tools of overseers of registered investment advisers, do not have jurisdiction over hedge funds, leaving the fund managers free to set hurdle rates as they deem appropriate.

How Many Hedge Funds Use Hurdle Rates?

About a quarter of hedge funds use hurdle rates. Initial indications are that that number remains fairly constant despite a healthy risk-free rate above 4%. The fact that the percentage of hedge funds that use hurdle rates is 27% is somewhat mystifying because investors seem to prefer it when such rates are in place. Indeed, there have been cases where certain hedge funds have either lost customers or failed entirely because of refusal on the part of their managers to adopt hurdle rates. This is the second part of the hurdle rates debate: whether or not simply to adopt them. 

Why Investors Want Hurdle Rates

It’s quite simple, really. Investors want to pay fewer and smaller fees. Let’s take an example of an investor who wants to invest $100. Further, let’s say that the hedge fund achieves a growth rate of 5% annually, which means that the investor receives $5 on the investment. Let’s also say that the average base and performance fee are the standard “2-and-20.” That means that the investor would pay roughly $3 ($100*0.02+$5*0.2) without a hurdle whereas the fees would be about $2.20 with a 4% hurdle ($100*0.02+$1*0.02, the first 4% of gains being the hurdle rate). Projected onto investments that amount to millions or billions, it’s easy to see the fees piling up. 

Fund Managers’ Reasoning Against Hurdle Rates

What do fund managers say when they defend their avoidance of hurdle rates? Their first line of defense is to say, “It’s a low-beta strategy.” That’s where the fund manager picks low-risk, low-volatility investments in an effort to reduce risk compared to the market as a whole. The idea is the hurdle rate isn’t needed because the fund manager is protecting the investment by reducing risk. This type of investment approach can be valuable for certain investors, but not all. 

Another common arguments against hurdle rates is that a fund manager may have low rates already. Further, they might also have a high watermark. These protect investors from paying high fees on poor returns. Being fair, 92% of hedge funds in the marketplace use high watermarks to protect their investors. Currently, the average base fee rate in hedge funds that use hurdle rates is 1.02%. In hedge funds where there are no hurdle rates, the average base fee rate is more than 25 basis points higher at 1.28%. 

The Effect of the Global Financial Crisis

From September 2008 until March of 2009, the global markets lost 54% of their value, and the American population lost $10.2 trillion. After that, people were leery of investing because so many of their friends lost everything. That leeriness led to the investor-centric model over the last 15 years. That’s why policies like high watermarks and hurdle rates became more prominent beginning in 2009. That same belief in protecting investors led to Congress enacting the Dodd-Frank Act, 848 pages of controls that protected them. 


Although hurdle rates are wanted by many investors, they still aren’t the norm. Depending on the fund strategy, a hurdle rate, high watermark, both or neither may be appropriate. The key is that there needs to be clarity in communication and trust between the fund manager and the investors. 

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