Two and Twenty: Hedge Fund Manager Compensation

The 'Two and Twenty' fee structure is a common compensation model for hedge fund managers, where 2% of total asset value is charged as a management fee and an additional 20% of profits is taken as a performance fee.

The “Two and Twenty” fee structure is a common compensation model employed by hedge fund managers. It combines a management fee of 2% of total asset value with a performance fee that typically amounts to 20% of the fund’s profits. This model aligns the interests of fund managers with those of their investors but has also been subject to criticism due to its potential to incentivize excessive risk-taking.

Management Fee

Definition and Calculation

The management fee is typically calculated as a percentage of the total assets under management (AUM). For the “Two and Twenty” structure, this fee is set at 2%.

$$ \text{Management Fee} = \text{AUM} \times 0.02 $$

Example

If a hedge fund manages $100 million in assets, the annual management fee would be:

$$ \$100,000,000 \times 0.02 = \$2,000,000 $$

Performance Fee

Definition and Calculation

The performance fee, also known as the incentive fee, is calculated as a percentage of the profits generated by the fund, typically 20%.

$$ \text{Performance Fee} = \text{Profits} \times 0.20 $$

Example

If a hedge fund generates $10 million in profits, the performance fee would be:

$$ \$10,000,000 \times 0.20 = \$2,000,000 $$

Historical Context

Origin

The “Two and Twenty” model has its roots in the early practices of hedge funds dating back to the mid-20th century. It gained popularity in the 1980s and 1990s as hedge funds became more prominent in the financial markets.

Evolution

While the “Two and Twenty” structure is still prevalent, it has faced competition from other fee models due to criticism over high costs and performance incentives that may encourage risky investments.

Applicability

Hedge Funds

This fee structure is primarily used by hedge funds, which are investment funds that employ various strategies to earn active returns for their investors. These strategies often include leveraging, derivatives, and short selling.

Comparisons with Mutual Funds

In contrast, mutual funds typically charge only a management fee, generally much lower than 2%, without a performance-based component. This makes mutual funds a more cost-effective option for average investors.

Related Terms and Definitions

AUM (Assets Under Management)

The total market value of assets that an investment firm or financial institution manages on behalf of clients.

High-Water Mark

A provision that ensures fund managers only earn performance fees on new profits, not on recovered losses.

Hurdle Rate

The minimum annual return that a fund must achieve before it can charge a performance fee.

FAQs

Why is the 'Two and Twenty' model controversial?

Critics argue that the high fees can erode investor returns and may encourage excessive risk-taking by fund managers.

Are there any alternatives to the 'Two and Twenty' model?

Yes, some funds employ flat fees, sliding-scale fees, or performance fees contingent on surpassing a hurdle rate.

What is a high-water mark in hedge fund compensation?

It is a provision ensuring managers only earn performance fees on new highs, which prevents them from charging fees on recovered losses.

References

1. Ackermann, Carl, Richard McEnally, and David Ravenscraft, “The Performance of Hedge Funds: Risk, Return, and Incentives,” The Journal of Finance, 1999.
2. Fung, William, and David A. Hsieh, “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds,” The Review of Financial Studies, 1997.

Summary

The “Two and Twenty” fee structure remains a cornerstone of hedge fund manager compensation. While it is designed to align the interests of managers and investors, it has faced scrutiny for its potential to incentivize high-risk investments. Understanding this model is crucial for investors who are considering investing in hedge funds.

By covering the basics and elaborating on detailed examples and related terms, this article has provided a comprehensive overview of the “Two and Twenty” fee structure, placing it within its historical and practical context.