Impact of Increased Interest Rates on Hedge Fund Earnings Post Fee Deductions
In a rising interest rate environment, hedge funds face significant changes in their fee structures, cash yields, and overall performance. This shift presents both challenges and opportunities for these investment vehicles.
Firstly, higher cash yields benefit hedge funds' bottom lines. In periods when Fed Funds rates exceed 5%, long/short equity hedge funds, for example, have historically delivered average monthly returns about 100 basis points higher compared to low-rate periods. This increased income is due to the higher yields earned on unencumbered cash holdings and short-term instruments like U.S. Treasuries or money market funds[1].
Secondly, as interest rates rise, institutional investors increasingly demand hurdle rates in hedge fund fee structures. This means that hedge funds must exceed a minimum return threshold before charging performance fees. Surveys show a sharp increase in investor preference for hurdle rates, reflecting their expectation of earning a "cash plus" return due to higher rates[2]. Despite this demand, only about 30% of hedge fund managers currently offer these hurdle-based fees, though many are considering changes to remain competitive by better aligning fees with performance in a higher-rate world[2].
Thirdly, higher rates can increase alpha opportunities for hedge funds by creating more dynamic market conditions. Funds using derivatives or futures benefit especially since their unencumbered cash can generate higher yields on collateral or margin balances, enhancing returns[1]. However, certain strategies like buyout funds that rely heavily on leverage may face headwinds from rising debt costs, which can indirectly affect hedge funds investing in private equity or credit strategies[5].
In summary, higher interest rates allow hedge funds to boost income through increased cash yields, while simultaneously pressuring them to adjust fee structures to include hurdle rates that reflect investors’ rising expectations for baseline returns. This environment can enhance certain hedge fund strategies' returns but also necessitates more investor-friendly fee arrangements[1][2].
Investors who pay attention to the economics of underlying fee structures and their implications will be better able to select funds that share this out-performance more equally between fund managers and investors. Implementing beta-oriented and/or cash hurdles could better align managers with investors, potentially capitalizing on increased dispersion in global asset price movements as short-term interest rates rise.
However, it's important to note that the traditional 2/20 fee model for hedge funds does not optimally align incentives with investors. For instance, if managers charged a higher performance fee of say 50% over a cash-based hurdle, investors could potentially be better off.
Despite a record level of assets under management ("AUM") in the hedge fund space, hedge fund alpha has been improving in certain areas. Attempts to solve some of these issues include clawbacks to performance fees, the "1 or 30" framework, or reduced management fees, but they do not address the economic giveaway that charging performance fees on beta or performance fees on cash would create.
As always, investors should be mindful of the effect of the performance fee drag on cash rates when negotiating fees with managers. The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group.
[1] "Hedge Fund Returns in a Rising Rate Environment," AlphaWeek, 12 May 2021,
[2] "Hurdle Rates: The New Trend in Hedge Fund Fees," AlphaWeek, 20 May 2021,
[3] "The Impact of Interest Rates on Hedge Fund Performance," AlphaWeek, 25 May 2021,
[4] "Optimising Hedge Fund Fees in a Rising Rate Environment," AlphaWeek, 1 June 2021,
[5] "The Role of Leverage in Hedge Fund Performance," AlphaWeek, 8 June 2021,
Engaging in personal-finance planning, investors might consider the implications of rising interest rates on their investment strategies, particularly with regard to hedge funds. In a climbing interest rate environment, such as when Fed Funds rates exceed 5%, institutional investors may increasingly demand hurdle rates in hedge fund fee structures, aiming to earn a "cash plus" return (personal-finance: returns). Additionally, this atmosphere can create alpha opportunities for hedge funds by offering more dynamic market conditions, particularly for funds employing derivatives or futures (investing).
