It's not easy for investors to gauge how successful a hedge fund is likely to be, but a manager's confidence in producing high returns as indicated by a fund's fee structure is one place to start.
Investors typically look at a fund's history, but they could also examine the composition of its assets to discover how much is new money and how much is true investment gains.
Hedge funds can typically charge between 1 to 2 percent annual management fees and up to 20 percent of any outperformance of pre-set targets such as money market rates.
However, some of the best performing long-established hedge funds have recently moved away from this model and are now charging performance fees only, sometimes up to 50 percent.
"Today, you are seeing excess demand for the managers with the highest fees and little demand for managers that are cutting fees," said Steven Drobny, founding partner of consultancy Drobny Global Advisors.
One high-profile example is US-based Clarium Capital with more than $1 billion under management, which returned more than 50 percent in 2003 and 2005 and charges only incentive fees of 25 percent.
Performance fees align the interests of investors and hedge funds, which should not be looking to boost management fees by asset gathering, in the way of traditional fund managers.
"There are some who charge 40 or 50 percent performance fees," said Sunil Chadda, head of hedge funds and derivatives at consultants Citisoft. "If you want performance you pay for it."
Traditional fund managers on average command annual management fees of half a percentage of assets and rarely any performance fees.
BEST AND WORST:
Over the past couple of years as the industry's assets have risen - around $1.5 trillion compared with $500 billion in 2000 - the fee differential between the best and worst has widened, even though the average has stayed steady.
Management fees for many are there to cover the costs of running a business.
"It's not realistic to think the industry can structure itself only on performance fees," said Nicolas Campiche, who heads a group that selects hedge fund managers for clients at Pictet et Cie.
"The risk for a fund that is running just on performance fees is that if one year it hits a soft patch in performance or maybe has a negative year then the business can't really be sustained."
But how can you tell if a hedge fund has hit a short period of weak returns or whether the problem is more ingrained?
Investors say the thing to do is look at the composition of a hedge fund's assets and work out how much is new money and how much is investment return.
High returns - 10 percent or more - would suggest the focus is on making money rather than asset gathering.
The size of assets too should reveal clues about how incentivised a manager is to produce high returns.
"Management fees shouldn't become large enough so the manager doesn't need to perform any more," Campiche said.
"For instance a $12 billion hedge fund charging a 2 percent management fee doesn't really need to perform to generate performance fees that are enough to sustain the firm."
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