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The 2 & 20 Hedge Fund Fees: How Does it Affect Me?

The 2 & 20 Hedge Fund Fees: How Does it Affect Me?

The compensation structure (2 and 20) of the hedge fund includes a management and performance fee. The first 2% is a management fee that applies to the entire asset with the management. In addition, all profits generated from the hedge fund have a 20% performance fee charge.

The 2% fee applies to the asset under management irrespective of the investment performance. The 20% fee, however, comes only when such a fund gets to a particular profit level.


How the Fee Structure Work 

The idea behind the fee structure is to finance the operations of the hedge funds. The 2% management fee is applied to the total Assets Under Management (AUM) and helps cover admin expenses and wages.  

The 20% fee for performance is directed at rewarding key executives and managers. Because of this bonus structure, hedge fund managers are some of the best paid finance professionals.


Calculation of the 20% Performance Fee

The most significant income source for hedge funds is the 20% performance fee. This fee is applied only when the profits in the funds get to a particular level. The threshold level commonly used is 8% implying that the 20% performance fee only applies when the profit for the year exceeds 8%


Justifying the 2 and 20 Fee Structure

A couple of investors believe that the 2 and 20% fee structure for a hedge fund is unreasonable. Regardless, this is the fee structure maintained in the industry for many years. This structure has survived because hedge funds have consistently generated high income for investors. As a result, clients do not mind the fees even if it seems excessive, as they get an impressive return on investment for their funds.


Antagonists of the 2 and 20 Hedge Fund Fee Structure 

Different categories of people – politicians, investors, etc. have criticized and even pressurized hedge funds due to their supposedly high fee structure. This can be traced to the fact that following the financial crisis of 2008, hedge funds could not keep up with their optimal performance like a series of other investments. This led to seeking out hedge funds charging higher fees to bring such down.

 Congress and other politicians have sought to have a sizable part of the profits of hedge funds sliced by having such profits taxed at ordinary income rate and not the lower capital gains rate. This industry, as of 2018, however, was able to maintain a lower tax rate with the argument that income is different from a fixed salary and a matter of performance.


Some alternative to the Fees Structure of Hedge Fund

A couple of hedge funds have adopted some alternative fee structure as discussed below:

  1. Shares for Founders

Businesses just starting alongside fresh hedge funds do give incentives to investors during the prime of their business. This incentive is called founders shares and entitles investors to a reduced fee structure like 1.5 and 10, not the high 2 and 20 fee structure. 

There is also the option to use a 2 and 20 fee structure with an agreement to bring down the fee when the fund gets to a particular milestone. For instance, one might be charged 2 and 20 for profits up to 22%, which gets reduced to 2 and 15 for earnings above the 22% threshold. 

  1. Discounts for Capital Lockup

Investors might qualify for impressive discounts with a hedge fund provided they agree to lock up their investment in the company for a particular period like four, six, or ten years. 

This is common practice with hedge funds having investments that need a long time frame before any impressive ROI can come out. The extended lockup period gives the client a reward of a lower fee structure.

 

High Water Mark Clause

Series of hedge funds come with a watermark clause that reveals that the hedge fund manager is only allowed to charge a performance fee after new profits from the fund. There cannot be a performance fee if the fund incurs losses, except after recovering such losses.


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