Two and Twenty

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 likewise common in venture capital and private equity. Hedge fund management companies normally charge clients both a management and a performance fee. "Two" means 2% of assets under management (AUM), and alludes to the annual management fee charged by the hedge fund for overseeing assets. "Twenty" alludes to the standard performance or incentive fee of 20% of profits made by the fund over a certain predefined benchmark. While this lucrative fee arrangement has brought about many hedge fund managers turning out to be very rich, in recent years the fee structure has experienced harsh criticism from investors and lawmakers for shifting reasons.

How Two and Twenty Works

The 2% management fee is paid to hedge fund managers no matter what the fund's performance. A hedge fund manager with $1 billion AUM procures $20 million in management fees annually even on the off chance that the fund performs poorly. The 20% performance fee is charged assuming the fund accomplishes a level of performance that surpasses a certain base threshold known as the hurdle rate. The hurdle rate could either be a preset percentage, or might be based on a benchmark, for example, the return on an equity or bond index.

Some hedge funds likewise need to contend with a high watermark that is applicable to their performance fee. A high watermark policy determines that the fund manager may be paid a percentage of the profits on the off chance that the fund's net value surpasses its previous highest value. This blocks the fund manager from being paid large totals for poor performance and guarantees 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 all in all made $7.7 billion in fees in 2018, taking their combined net worth to $70.7 billion, as per Bloomberg. The table below shows the main five fund managers who rounded up the most in 2018.

The monster hedge funds established by these fund titans developed so large that they generated many millions in management fees alone. Their effective strategies over numerous years - on the off chance that not decades - have likewise earned these funds billions in performance fees. While the precarious fees charged by star hedge fund managers might be justified by their supported outperformance, the billion-dollar question is whether the majority of fund managers generate adequate returns to legitimize their Two and Twenty fee model.

Is Two and Twenty Justified?

Jim Simons, the highest-paid hedge fund manager in recent years, established Renaissance Technologies in 1982. An honor winning mathematician (and former NSA code breaker), Simons laid out Renaissance as a quant fund that utilizes sophisticated quantitative models and procedures in its trading strategies. One of the world's best hedge funds, Renaissance is best known for the tremendous returns generated by its lead Medallion fund. Simons sent off Medallion in 1988 and over the course of the next 30 years, it generated an average annual return of around 40%, including an average return of 71.8% annually somewhere in the range of 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 starting around 2005 and presently just oversees money for Renaissance employees. Renaissance had $75 billion in AUM as of April 2020, so even however Simons ventured down as its head in 2010, those outsized fees ought to keep adding to the growth in his net worth.

In any case, such stellar performances tend to be the exception as opposed to the standard in the hedge fund industry. While hedge funds, by definition, are expected to bring in money in any market as a result of their ability to go long and short, their performance has lagged equity indices for quite a long time. In the decade from 2009 to 2018, hedge funds had an average annualized return of 6.09 percent, as per data provider Hedge Fund Research (HFR), not exactly 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 (counting dividends ) of - 4.38%.

Based on data from HFR, an analysis by CNBC revealed that 2018 was the initial opportunity in a decade that hedge funds had beated the S&P 500, albeit just barely.

Warren Buffett, in his February 2017 letter to Berkshire Hathaway shareholders, estimated that the hunt by the financial "first class" -, for example, affluent people, pension funds and college endowments, every one of whom tend to be commonplace hedge fund investors - for better investment exhortation has caused it than squander more than $100 billion in aggregate over the course of the last decade.

Two and Twenty Updated

Ongoing underperformance and high fees are making investors bail out of hedge funds, with a net $94.3 billion removed starting from the beginning of 2016. Strong performances by most markets empowered hedge fund industry assets to increase by $78.8 billion in the main quarter of 2019 to $3.18 trillion worldwide, around 2% below the record level of $3.24 in the second from last quarter of 2018, as per HFR.

The expansion of hedge funds, with more than 11,000 estimated to be in operation today compared with less than 1,000 funds 30 years prior, has additionally brought about some downward pressure on fees. The average fund as of now charges a management fee of 1.5% and 17% performance fee, compared with 1.6% and 20% 10 years prior.

Hedge fund managers are additionally going under pressure from legislators who need to rename performance fees as ordinary income for tax purposes, instead of capital gains. While the 2% management fee charged by hedge fees is treated as ordinary income, the 20% fee is treated as capital gains on the grounds that the returns are normally not paid out however are treated as though they were reinvested with the fund investors' monies. This "conveyed revenue" in the fund empowers 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%, rather than the top ordinary rate of 37%. In March 2019, Congressional Democrats once again introduced legislation to end the much-criticized "conveyed interest" tax break.

An Example of Two and Twenty

Expect speculative hedge fund Peak-to-Trough Investments (PTI) had $1 billion in AUM toward the beginning of Year 1, and is closed to investors. The fund's AUM develops to $1.15 billion toward the end of Year 1, yet toward the end of Year 2, AUM tumbles to $920 million, before bouncing back to $1.25 billion toward the end of Year 3. In the event that the fund charges the standard "Two and Twenty", the total annual fees made by the fund toward the end of every 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 surpassed

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

Highlights

• Two alludes to the standard management fee of 2% of assets annually, while 20 means the incentive fee of 20% of profits over a certain threshold known as the hurdle rate.
• This lucrative fee arrangement has brought about many hedge fund managers becoming multi-tycoons or even extremely rich people, however has come under close examination from investors and government officials in recent years.
• A high watermark might be applicable to the performance fee; it indicates that the fund manager may be paid a percentage of profits assuming the fund's net value surpasses its previous highest value.