Two and Twenty

Two and twenty is a compensation structure that hedge fund managers typically employ in which part of compensation is performance-based. More specifically, this phrase refers to how hedge fund managers charge a flat 2% of total asset value as a management fee and an additional 20% of any profits earned.

The 2% management fee is paid to hedge fund managers regardless of the fund’s performance. A hedge fund manager with $1 billion of assets under management (AUM) earns $20 million even if the fund performs poorly. The 20% profit fee is only paid once the fund achieves a level of performance that exceeds a certain profit threshold, typically around 8%. Some investors, who have never paid the 20% fee because there haven’t been any profits, consider the 2% management fee to be too high relative to the overall performance of many funds.

Famous value investor Warren Buffett has opined in a letter from Feb. 25, 2017 that "My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative." According to Buffett, very wealthy investors are accustomed to superior service and products in other areas of life, and they mistakenly think superior products and services are also available in financial services, which in his view is a mistake. They end of wasting trillions of dollars on overly complex and ineffectual hedge fund strategies. 

One the world’s most successful hedge funds since 1994 has been Renaissance Technologies, led by Jim Simons, a former NSA code breaker. In 2015, the fund had $65 billion in AUM and generated $3.2 billion in annual management fees. Because of his remarkable outsized returns over the years, he also charged a 44% profit fee. It is estimated that his hedge fund returned an average 71.8% between 1994 and 2014. The fund's worst performance between 2001 and 2013 was a 21% gain. When asked by investors why his profit fee is so high, he responds by telling them they can leave if they want — but few do.

Due to their underperformance or inconsistent performance, many hedge fund managers have come under pressure to reduce their fees. Investors have been redeeming assets with poor-performing hedge funds at a record pace, with a large portion being reallocated to larger funds with stronger track records. To stop the bleeding, hedge fund managers have been complying. In 2015, the average fee arrangement stood at 1.5% of assets and 17.7% of profits. However, the top-performing hedge funds still charge 20% or more.

Investors are not the only ones complaining about high fees. Hedge fund managers are also coming under pressure from politicians who want to reclassify the profit fees as ordinary income for tax purposes. As of 2016, their profit fees, also referred to as carried interest, are classified as capital gains, which are taxed more favorably. Fund managers contend that carried interest is not a salary, but that it is an at-risk return on investment payable based on performance. The Tax Cuts and Jobs Act of 2017 left the carried interest tax loophole intact, though some states now are looking to levy an additional tax on hedge funds, private equity and venture capital firms, and some real estate investors on top of the capital gains tax they already pay to the federal government.