Two and Twenty: Explanation of the Hedge Fund Fee Structure

What Is Two and Twenty?

Two and twenty (or "2 and 20") is a fee arrangement that is standard in the hedge fund industry and is also common in venture capital and private equity. Hedge fund management companies typically charge clients both a management and a performance fee. "Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. While this lucrative fee arrangement has resulted in many hedge fund managers becoming extremely wealthy, in recent years the fee structure has come under fire from investors and politicians for varying reasons.

How Two and Twenty Works

The 2% management fee is paid to hedge fund managers regardless of the fund’s performance. A hedge fund manager with $1 billion AUM earns $20 million in management fees annually even if the fund performs poorly. The 20% performance fee is charged if the fund achieves a level of performance that exceeds a certain base threshold known as the hurdle rate. The hurdle rate could either be a preset percentage, or may be based on a benchmark such as the return on an equity or bond index.

Some hedge funds also have to contend with a high watermark that is applicable to their performance fee. A high watermark policy specifies that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value. This precludes the fund manager from being paid large sums for poor performance and ensures that any losses must be made up before performance fees are paid out.

Two and Twenty: Adding up to Billions

The ten highest-paid hedge fund managers collectively made $7.7 billion in fees in 2018, taking their combined net worth to $70.7 billion, according to Bloomberg. The table below shows the top five fund managers who raked in the most in 2018.

The giant hedge funds founded by these fund titans grew so large that they generated hundreds of millions in management fees alone. Their successful strategies over many years - if not decades - have also earned these funds billions in performance fees. While the steep fees charged by star hedge fund managers may be justified by their sustained outperformance, the billion-dollar question is whether the majority of fund managers generate sufficient returns to justify their Two and Twenty fee model.

Is Two and Twenty Justified?

Jim Simons, the highest-paid hedge fund manager in recent years, founded Renaissance Technologies in 1982. An award-winning mathematician (and former NSA code breaker), Simons established Renaissance as a quant fund that employs sophisticated quantitative models and techniques in its trading strategies. One of the world’s most successful hedge funds, Renaissance is best known for the tremendous returns generated by its flagship Medallion fund. Simons launched Medallion in 1988 and over the next 30 years, it generated an average annual return of about 40%, including an average return of 71.8% annually between 1994 and 2014. Those returns are after Renaissance's management fees of 5% and performance fees of 44%. Medallion has been closed to outside investors since 2005 and currently only manages money for Renaissance employees. Renaissance had $75 billion in AUM as of April 2020, so even though Simons stepped down as its head in 2010, those outsized fees should continue contributing to the growth in his net worth.

But such stellar performances tend to be the exception rather than the norm in the hedge fund industry. While hedge funds, by definition, are expected to make money in any market because of their ability to go long and short, their performance has lagged equity indices for years. In the ten years from 2009 to 2018, hedge funds had an average annualized return of 6.09 percent, according to data provider Hedge Fund Research (HFR), less than half of the S&P 500's 15.82% annual return over this period. In 2018, hedge funds returned -4.07% versus the S&P 500's total return (including dividends ) of -4.38%.

Warren Buffett, in his February 2017 letter to Berkshire Hathaway shareholders, estimated that the search by the financial "elite" - such as wealthy individuals, pension funds and college endowments, all of whom tend to be typical hedge fund investors - for superior investment advice has caused it to waste more than $100 billion in aggregate over the past decade.

Two and Twenty Updated

Chronic underperformance and high fees are causing investors to bail out of hedge funds, with a net $94.3 billion withdrawn since the beginning of 2016. Strong performances by most markets enabled hedge fund industry assets to increase by $78.8 billion in the first quarter of 2019 to $3.18 trillion globally, about 2% below the record level of $3.24 in the third quarter of 2018, according to HFR.

The proliferation of hedge funds, with more than 11,000 estimated to be in operation today compared with fewer than 1,000 funds 30 years ago, has also resulted in some downward pressure on fees. The average fund currently charges a management fee of 1.5% and 17% performance fee, compared with 1.6% and 20% 10 years ago.

Hedge fund managers are also coming under pressure from politicians who want to reclassify performance fees as ordinary income for tax purposes, rather than capital gains. While the 2% management fee charged by hedge fees is treated as ordinary income, the 20% fee is treated as capital gains because the returns are typically not paid out but are treated as if they were reinvested with the fund investors' monies. This "carried interest" in the fund enables high-income managers in hedge funds, venture capital and private equity to have this income stream taxed at the capital gains rate of 23.8%, instead of the top ordinary rate of 37%. In March 2019, Congressional Democrats reintroduced legislation to end the much-reviled "carried interest" tax break.

An Example of Two and Twenty 

Assume hypothetical hedge fund Peak-to-Trough Investments (PTI) had $1 billion in AUM at the beginning of Year 1, and is closed to investors. The fund's AUM grows to $1.15 billion at the end of Year 1, but by the end of Year 2, AUM falls to $920 million, before rebounding to $1.25 billion by the end of Year 3. If the fund charges the standard "Two and Twenty", the total annual fees made by the fund at the end of each year can be calculated as follows -

Year 1:

Fund AUM at beginning of Year 1 = $1,000M

Fund AUM at end of Year 1 = $1,150M

Management fee = 2% of year-end AUM = $23M

Performance fee = 20% of fund growth = $150M x 20% = $30M

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

Year 2:

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

Fund AUM at end of Year 2 = $920M

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

Performance fee = Not payable as high watermark of $1,150M has not been exceeded

Total fund fees = $18.4M

Year 3:

Fund AUM at beginning of Year 3 = $920M

Fund AUM at end of Year 3 = $1,250M

Management fee = 2% of year-end AUM = $25M

Performance fee = 20% of fund growth above high watermark = $100M x 20% = $20M

Total fund fees = $25M +$20M = $45M