Explanation:
For investing directly $50 million in the hedge fund:
$50 million × 10% = $5 million profit
Management fee: $50 million × 2% = $1 million gross profit
Incentive fee (independent of management fee): $5 million × 0.20 = $1 million
Total fees = $1 million + $1 million = $2 million
Return: ($5 million − $2 million) / $50 million = 6%
For investing $60 million in the FOF:
$60 million × 5% = $3 million gross profit
FOF management fee: $60 million × 1% = $0.6 million
Incentive fee: $3 million × 0.10 = $0.3 million
Return: ($3 million − $0.6 million − $0.3 million) / $60 million = 3.5%
So 6% − 3.5% = 2.5%. The direct hedge fund return is 2.5% greater than the FOF return.
Q.3503 Rosy Garcia is considering investing in a hedge fund or a fund of funds.
Garcia invests $50 million in the hedge fund and receives a yearly gross return of 10%. The fund has a '2 and 20' fee structure with no hurdle rate, and management fees are calculated on an annual basis on assets under management at the beginning of the year. Incentive fees are calculated independently of management fees.
Garcia also invests $60 million in a fund of funds (FOF) and earns a 5% yearly gross return. Assuming that the fund of funds fee structure is '1 and 10' and that all other fee structures in the FOF are similar to that of the hedge fund, the return to the investor of investing directly in the hedge fund will be:
A
2.5% greater than the return generated by investing in the FOF.
B
2.3% greater than the return generated by investing in the FOF.
C
3.1% greater than the return generated by investing in the FOF.
D
Lower than the return generated by investing in the FOF.
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