[imcoconut]

These days a lot of the money in Hedge Funds is institutional. Typically institutional investors coming to funds already have a specific allocation to an investment style, market, or asset class that they are trying to fill. So they already have an idea of whether they want market exposure, which would be benchmark oriented and should have high correlation to the benchmark/market, or whether they want no market exposure, which would would have low to zero correlation to the market (they also could want exposure anywhere in between). So in long only (no shorting) funds benchmarks can be arbitrary (though are usually indexes), but they are fixed and agreed upon by manager and investor.

The mandate for the manager in benchmark oriented strategies is to track the agreed upon benchmark with a correlation (or more accurately Beta) of as close to 1 as possible, while still beating it by a certain margin. So if the benchmark is up 10, the fund should be up 15. If the benchmark is down -10 the fund should be down -5. Technically, this margin is often measured not as the difference between the fund and the benchmark but as the annualized standard deviation of the difference, known as the Tracking Error(TE). The TE is typically agreed upon between the fund and investor(s).

It's very common for a fund to charge only a management fee in benchmark oriented strategies. In a benchmark oriented fund with a target TE it would not really make sense to charge performance fee on the magnitude total fund performance since that will largely (or completely) be a function of the benchmark/market - remember correlation should be 1. It also would not make sense to charge performance fee on the excess return over the benchmark because that is incorporated into the TE and should be relatively constant over time (in the example earlier the fund should always beat the benchmark by %5.

So usually there is just the management fee. The reasoning is that if a fund can yield consistently high returns with a consistently low risk (as measured by vol/std. dev. of excess returns a.k.a. TE) then they have some skill and should be compensated accordingly. The excess returns adjusted by risk of excess returns is called Information Ratio (IR). IR is analogous to Sharpe Ratio(SR) in non benchmark oriented funds. In a long/short fund, the higher the SR the higher the fees usually. Similarly, in the long only benchmark oriented fund, the higher the IR the higher the management fee.

This is how fees usually are determined for funds that have benchmarks.