Fixed-Income Returns from Hedge Funds with Negative Fee Structures: Valuation and Risk Analysis

The traditional fixed-income asset class has generated very low returns in recent years. Furthermore, due to long-term market trends it is arguably perceived by investors to be riskier and less diversifying than it has ever been. This has led to the emergence of new products that are designed to appeal to institutional investors in their quest for finding complementary return streams, particularly for liability driven investment (LDI). These bond-like products are often augmented with equity-like positions in investors’ portfolios in an attempt to mitigate risk and generate attractive returns. In this paper, we analyze fee structures that have emerged in the hedge fund industry. In particular, we study structures with ‘negative fees,’ which give hedge fund investments risk-return profiles that more closely resemble traditional fixed-income investments. We analyze the value and risk-return profiles of these investments, and study the incentives that the fee structures create for fund managers. In this paper we discuss how the employment of judicious fee structures in combination with suitable trading strategies can assist in accommodating the appetite of a wide range of investors. We will present a spectrum of fee structures where investors can pinpoint a region of interest which fulfills their desired payoff profile.