Two and Twenty: Explanation of the Hedge Fund Fee Structure

What are two and twenty?

Two and Twenty: Hedge fund managers get their 2% management fee regardless of how well the fund performs. Even if the hedge fund performs poorly, a manager with $1 billion in assets under management (AUM) receives $20 million in management fees annually. If the fund’s performance is above a basic threshold known as the hurdle rate, a 20% performance fee will be assessed. The hurdle rate may be determined by reference to a benchmark, such as the return on an index of bonds or stocks, or it may be set at a fixed percentage.

A high watermark that is applied to their performance fee is another issue that some hedge funds face. According to a high watermark policy, the fund management will only get a portion of the profits if the fund’s net worth rises above its most significant value in the past. This guarantees that any losses must be made up before performance fees are paid and prevents fund management from receiving vast amounts of money for subpar performance.

How Two and Twenty Works

According to Bloomberg, the ten hedge fund managers who received the highest compensation in 2018 earned a combined $7.7 billion in fees, bringing their total net worth to $70.7 billion.

Source: Bloomberg

These finance giants created enormous hedge funds that amassed enormous profits in management fees, amounting to hundreds of millions of dollars. These funds have received billions in performance fees from their long-term, successful strategies. The big issue is whether most fund managers produce enough returns to support their Two and Twenty fee model, even if their consistent outperformance may justify the high fees paid by elite hedge fund managers.

Are two and twenty appropriate?

Renowned hedge fund manager Jim Simons started Renaissance Technologies in 1982. A former NSA codebreaker and award-winning mathematician, Simons founded Renaissance as a quant fund that uses advanced quantitative models and methods in its trading strategies. Renaissance, one of the most successful hedge funds in the world, is primarily known for the enormous profits generated by its flagship Medallion fund. When Simons debuted Medallion in 1988, it produced returns of around 40% annually on average over the following thirty years, with an exceptional return of 71.8% annually from 1994 to 2014. These returns are net of Renaissance’s 44% performance fee and 5% management charge. Since 2005, Medallion has yet to accept new investors and now exclusively looks after the funds of Renaissance staff members. Even though Simons left his position as CEO of Renaissance in 2010, his $75 billion in AUM as of April 2020 suggests that the excessive fees he paid there should continue to add to his wealth.

However, in the hedge fund business, these outstanding results are more often the exception than the rule. Due to their ability to trade both long and short, hedge funds are by definition expected to profit in any market; however, for several years, their performance has trailed equities indices. According to data provider Hedge Fund Research (HFR), over the ten years from 2009 to 2018, the average annualized return of hedge funds was 6.09 percent, which was less than half of the 15.82% annual return of the S&P 500. Compared to the S&P 500’s total return (including dividends) of -4.38% in 2018, hedge funds saw a return of -4.07%.

Hedge funds outperformed the S&P 500 in 2018 for the first time in ten years, according to an analysis by CNBC based on data from HFR, albeit by a very narrow margin.

In a February 2017 letter to Berkshire Hathaway shareholders, Warren Buffett estimated that over the past ten years, the financial “elite”—which includes wealthy individuals, pension funds, and college endowments, all of whom are typically typical hedge fund investors—has wasted over $100 billion in aggregate searching for better investment advice.

Twenty-Two Revised

Investors are fleeing hedge funds due to persistent underperformance and exorbitant fees; since 2016, a net of $94.3 billion has been withdrawn. Assets in the hedge fund sector increased by $78.8 billion in the first quarter of 2019 to $3.18 trillion worldwide, almost 2% less than the record level of $3.24 in the third quarter of 2018, thanks to solid results by major markets, according to HFR.

Hedge fund proliferation has also caused some downward pressure on fees; over 11,000 funds are estimated to be in operation today, compared with less than 1,000 funds thirty years ago. A decade ago, the average fund charged 1.6% and 20% for performance fees, while today’s average charges are 1.5% for management and 17% for performance.

Politicians who wish to reclassify performance fees as ordinary income rather than capital gains are also putting pressure on hedge fund managers. Since the returns from hedge funds are usually not paid out and are treated as if reinvested with the fund investors’ money, the 20% management fee charged by hedge funds is treated as capital gains. In contrast, the 2% management fee is treated as ordinary income. High-income managers in hedge funds, venture capital, and private equity can tax their income stream at the capital gains rate of 23.8% rather than the highest ordinary rate of 37%, thanks to this “carried interest” in the fund. Democrats in Congress reintroduced legislation in March 2019 to eliminate the much-maligned “carried interest” tax break.

An Illustration of Twenty and Two

Assume the fictional hedge fund Peak-to-Trough Investments (PTI) has $1 billion in AUM at the beginning of Year 1 and is closed to investors. After the first year, the fund’s AUM rose to $1.15 billion, but at the end of the second year, it dropped to $920 million, and by the end of the third year, it had risen to $1.25 billion. The total yearly fees collected by the fund at the end of each year may be computed as follows if it charges the typical “two and twenty” fees:.

Year 1:

Fund AUM at the start of Year 1 is $1,000 million.

At year’s end, the fund’s AUM was $1,150 million.

Management fee: $23 million (2% of year-end AUM).

15% of fund growth x performance fee = $150 million x 20% = $30 million

Total fund fees = $23M +$30M = $53M

Year 2:

Fund AUM at the beginning of Year 2 = $1,150M

Fund AUM at the end of Year 2 = $920M

Management fee = 2% of year-end AUM = $18.4M

Performance fee: not due since the high watermark of $1,150 million has not been surpassed

Total fund fees = $18.4 million

Year 3:

$920 million was the fund’s AUM at the start of Year 3.

At year’s end, fund AUM was $1,250 million.

The management fee is $25,000 (2% of year-end AUM).

Performance fee: $20 million for every $100 million over the high watermark in fund growth.

$25M plus $20M equals $45M in total fund fees.

Conclusion

• Twenty is the incentive charge of 20% of earnings beyond a threshold known as the hurdle rate. The second is the regular management fee of 2% of assets annually.
• Many hedge fund managers have become multimillionaires or even billionaires due to this attractive fee structure, but investors and governments have closely monitored it in recent years.
• The performance fee may be subject to a high watermark, which states that the fund management will only be paid a portion of the profits if the fund’s net value rises over its prior peak.