Hedge fund managers who lose money or underperform their benchmarks can find themselves closing up shop in a hurry unless they have deep pockets, loyal investors or another strategy that's doing well.
Sometimes, it takes only months for a hedge fund to go from successful to closed. The reason has to do with the fees hedge funds rely on to stay in business.
Hedge funds charge investors two kinds of annual fees: A management fee that averages about 1% of assets under management, depending on the fund, and a performance fee that averages about 20% of the profits the fund generates in excess of some benchmark.
In order to collect the more lucrative performance fee, however, hedge fund managers must beat their benchmark, also called a hurdle rate. It is often some kind of risk-free rate like the return on a one-year U.S. Treasury note or the London Interbank Offered Rate, plus some agreed-upon incremental figure. So a hurdle rate might be expressed as "the Salomon Smith Barney three-month U.S. Treasury Bill index, plus 5%." A hedge fund would have to generate a return in excess of whatever that hurdle rate turns out to be in order to earn its performance fee.
Furthermore, most hedge funds have what is called a "high-water mark," the level of assets under management below which the fund cannot charge a performance fee, regardless of the hurdle rate. Think of it this way: If a hedge fund manager starts out with $100 million, and loses $10 million during the year, he cannot start charging a performance fee until he first makes up the money he lost and then beats the hurdle rate.