Two and Twenty: Explanation of the Hedge Fund Fee Structure (2024)

Highest-paid hedge fund managers in 2018
OwnerFirmTotal hedge fund income in 2018 (US$)
James SimonsRenaissance Technologies$1,600,000,000
Ray DalioBridgewater Associates$1,260,000,000
Ken GriffinCitadel $870,000,000
John OverdeckTwo Sigma $770,000,000
David SiegelTwo Sigma $770,000,000

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%.

Based on data from HFR, an analysis by CNBC revealed that 2018 was the first time in a decade that hedge funds had outperformed the S&P 500, although only by a wafer-thin margin.

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 TwentyUpdated

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 =$100Mx 20% =$20M

Total fund fees = $25M +$20M=$45M

Two and Twenty: Explanation of the Hedge Fund Fee Structure (2024)


Two and Twenty: Explanation of the Hedge Fund Fee Structure? ›

"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.

What is a hedge fund 2 and 20 fee structure? ›

The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.

What you mean by 2 20 ratio in PE funds? ›

Many private equity firms charge a two-and-twenty fee structure. Fund investors must therefore pay 2% per year of assets under management (AUM) plus 20% of returns generated above a certain threshold known as the hurdle rate.

What is the 2 20 rule in PE? ›

The 2 represents the 2% annual management fee on capital deployed that is used to pay salaries, cover overheads and generally "keep the lights on." The 20 represents the 20% carry over of a certain return threshold that the private equity firm gets to keep.

What does 20 carry mean? ›

The typical carried interest rate charged to LPs is 20%—although some GPs can command higher rates. This means that after the LPs are repaid their original investment amount, the GPs will receive 20% of the profits from the fund, while the remaining 80% of profits are paid to the LPs.

What is a hedge fund fee structure? ›

A "2 and 20" annual fee structure—a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits—is a standard practice among hedge funds.

What is the fee structure of a hedge fund of funds? ›

The fee is typically 2% of a fund's net asset value (NAV) over a 12-month period. A performance fee: also known as an incentive fee, this second fee is viewed as a reward for positive returns. Performance fees are typically set at 20% of the fund's profits.

What is the hurdle rate 2 and 20? ›

A two-and-20 arrangement is a common fee structure for hedge funds, private equity, and venture capital firms. The fund charges investors 2% of assets under management plus 20% of profits over a hurdle rate annually.

What is an example of a fee structure? ›

How Fee Structures Work. The fee structure for an online auction website, for example, would list the cost to place an item for sale, the website's commission if the item is sold, the cost to display the item more prominently in the site's search results and so on.

What is the 2 20 rule for hedge funds? ›

"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.

What is Lynch's rule of 20? ›

Higher discount rates naturally equate to lower equity valuations. One simplistic measure of this is Peter Lynch's Rule of 20. This suggests that stocks are attractively priced when the sum of inflation and market P/E ratios fall below 20. Today CPI is running at 6.4% year over year, and P/Es for the S&P 500 are 18.3x.

What is the 80-20 rule activities? ›

Recognizing your 20 percent

Simply put, the 80/20 rule states that the relationship between input and output is rarely, if ever, balanced. When applied to work, it means that approximately 20 percent of your efforts produce 80 percent of the results.

What is the 2 and 20 VC model? ›

The 2 and 20 fee structure is a compensation model commonly used by venture capitalists. It involves a fixed management fee (typically 2% of the total asset value) and a performance fee (usually 20% of the fund's profits) that the VC manager receives.

What is a 20 carry fee? ›

Carried interest serves as the primary source of compensation for the general partner, typically amounting to 20% of a fund's returns. The general partner passes its gains through to the fund's managers. Many general partners also charge a 2% annual management fee.

What is an example of a hedge fund carried interest? ›

Carried Interest Example

For example, a hedge fund has $100 million of invested capital from 10 investors. The hedge fund has told the investors to expect at lease a 5% return on their investment. In addition, the fund manager will earn a 20% carry on the profits above the 5% hurdle rate.

What is a 1 or 30 hedge fund fee? ›

A common option is for the manager to take a 1% management fee with a reduction of the same amount to the performance fee so that total fees are capped at 30%. If the 1% management fee exceeds 30% of alpha during the performance period, any performance fee not recouped is carried forward to subsequent years.

Are hedge fund fees worth it? ›

Hedge funds have costly fees that normally include an asset management fee of 1% to 2% and a 20% performance fee on profits. Hedge fund managers eventually end up with more money than their clients because of those fees, so most investors are better off with other investment products.

What is a hedge fund structure? ›

Hedge funds are investment vehicles available to investors meeting certain net worth criteria. A typical hedge fund structure includes one entity formed as a partnership for U.S. tax purposes that acts as the Investment Manager (IM). Another entity functions as the General Partner (GP) of the Master Fund.

What is the fee structure of Citadel hedge fund? ›

Citadel charges a management fee to each of the funds under its control. This fee is equal to 1% of the fund's net asset value. Aside from this, there is no general fee schedule for investors in the funds at Citadel. The firm does, however, charge performance-based fees on occasion.

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