Over time, stocks have returned 10% per year.  If one hires a typical hedge fund that charges fees of 2% of assets and 20% of profits, to attain the same level profits as the market over time, the hedge fund manager must generate 14.5% before fees. 

If one hires a typical hedge fund of fund manager, which charges fees of 1% of the assets and 10% of the profits on top of the fees charged by the hedge fund, then the manager must generate just under 17% to break even with the long-term return on stocks.

How probable is it that the typical hedge fund manager will generate at least 14.5-17% per year on average just to generate a return after fees that equals an index fund?  Consider that over his illustrious career, Warren Buffett – generally acknowledged as one of the best investors, if not the greatest investor, ever – has returned a bit over 20% per year on average for five decades.  In other words, not likely.

If a manager can consistently earn after-fee returns of 10% per year with little volatility, such a fee structure is worth paying.  However, even though the average hedge fund is less volatile, it is not substantially so.

Much of the outsized return generated by hedge funds is due to leverage.  You can do that yourself.  As we wrote recently, you can generate private equity returns by using leverage without paying the high fees.

I am not against hedge funds per se, I just cannot see why anyone would pay such egregious fees.  Others see it differently. 

I think the best fee structure is for a manager to receive a cut, say 25%, of the profits above some benchmark, maybe 8%-10% per year, with a high-water mark.  If the manager earns less than that, they are paid nothing.

Otherwise, the current hedge fund fee structure is an asymmetrical bet for the hedge fund manager, since he will capture most of the alpha and you will take all of the losses.