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As I mentioned in Wednesday’s overview, hedge funds often come under fire for their fairly exorbitant fee structure. The “industry standard” is 2 percent of the total amount under management plus 20 percent of whatever gains the fund is able to generate. The more high-flying funds can go up from there: according to Barron’s magazine, Amaranth charges 2.5 percent of assets under management and 30 percent of gains.

Let’s go through a couple of examples to illustrate the effect that these fees have on total return. How much profit would a fund like Amaranth have to generate in order to deliver a given after-fee return to their clients?

To start, let’s say that you had $100,000 that you were considering putting either into the Amaranth Partners fund or into a one-year CD (a “certificate of deposit,” offered by banks everywhere, that promises a certain rate of return if you promise to hand your money over for 1 year.)

Right now, ING Direct (an online bank where I have a savings account and which appears to be perfectly legit) is offering 1 year CDs at a rate of 5.2 percent. Because the CDs are FDIC insured, this represents an essentially risk-free rate of return if you are willing to tie your capital up for a year. At the end of the year, you would have a gain of $5,200.

If the folks running Amaranth just put your money in a 1 year CD, you would not get back 5.2 percent. First they’d deduct 30 percent of that 5.2 percent return. Then they would take 2.5 percent of the whole amount under management. Assuming that the principal investment climbed steadily throughout the year, the assets-under-management fee would end up at 2.6 percent of the original amount. After all was said and done, Amaranth would end up having cleared $4,125 in fees, leaving you with a meager return of $1,075.

Tallying things up, the 1 year CD would return 5.2 percent, while the hedge fund investing in a 1 year CD would return just 1.1 percent.

What if you up the ante a bit? Let’s assume that you can buy an investment that you think will return 10 percent for the year. If you bought this investment yourself with the same $100,000, your return would naturally be 10 percent or $10,000. If Amaranth bought into that same 10-percent yielding asset, the fund would end up taking $5,625 in fees, leaving you with $4,375. This would be less than a 4.4 percent return – not even as good as the riskless return you could get from a CD.

Just to hit the county pension fund’s 8.25 percent target, a fund with Amaranth’s fee structure would have to generate pre-fee returns of 15.6 percent per year.

Of course, most hedge funds don’t invest in CDs or even in assets that they think will yield a meager 10 or 15 percent. They seek far better returns than that.

This really gets to the point of these examples: the hefty fee structure employed by hedge funds raises the bar for the returns those funds need to generate in order to justify their existence. And as Amaranth Partners demonstrated, many players in the increasingly competitive hedge fund universe have responded by placing bigger and riskier bets in their relentless pursuit of the big winners.

– RICH TOSCANO

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