Two and twenty (or “2 and 20”) is a common fee arrangement in the hedge fund industry, venture capital, and private equity. Fund managers typically charge both a management fee and a performance fee. “Two” signifies 2% of assets under management (AUM), referring to the annual management fee charged by the fund. “Twenty” indicates the incentive or performance fee of 20% of the profits made by the fund above a set benchmark. While this lucrative arrangement has made many hedge fund managers extremely wealthy, it has also come under scrutiny from investors and politicians for various reasons.
Key Insights
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Management Fee (Two): The standard management fee of 2% is charged annually based on the assets under management.
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Performance Fee (Twenty): Incentive fee of 20% of the profits that exceed a hurdle rate, ensuring the manager gets compensated for better-than-benchmark performance.
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Scrutiny: While managers often become multi-millionaires or billionaires, the fee structure faces scrutiny due to concerns about performance and fairness.
How Two and Twenty Works
The 2% management fee is paid to hedge fund managers regardless of fund performance. A hedge fund manager overseeing $1 billion in AUM would earn $20 million in management fees annually, irrespective of the fund’s success. The 20% performance fee is applicable only when the fund surpasses a predefined hurdle rate — which could be a fixed percentage or tied to benchmarks such as equity or bond indices.
Some hedge funds operate with a high watermark policy for performance fees. A high watermark ensures fund managers are only paid a percentage of profits if the fund’s net value exceeds its previous highest value. This prevents managers from earning large sums during periods of poor performance and ensures that any losses are recovered before performance fees are paid out.
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Two and Twenty: Adding up to Billions
In 2018, the ten highest-paid hedge fund managers collectively earned $7.7 billion in fees, increasing their combined net worth to $70.7 billion according to Bloomberg. Below are the top five managers for that year:
| Owner | Firm | 2018 Hedge Fund Income (US$) |
|---|---|---|
| James Simons | Renaissance Technologies | $1,600,000,000 |
| Ray Dalio | Bridgewater Associates | $1,260,000,000 |
| Ken Griffin | Citadel | $870,000,000 |
| John Overdeck | Two Sigma | $770,000,000 |
| David Siegel | Two Sigma | $770,000,000 |
Is Two and Twenty Justified?
Ray Dalio’s Renaissance and Stellar Returns
James Simons of Renaissance Technologies epitomizes the lucrative potential of the Two and Twenty model. An award-winning mathematician and former NSA codebreaker, Simons founded Renaissance in 1982, establishing it as a leading quant fund. Its flagship Medallion fund has generated remarkable average returns of about 40% annually over three decades, justifying its high 5% management and 44% performance fees. Although closed to external investors since 2005, Medallion exclusively benefits Renaissance employees and had $75 billion in AUM as of April 2020.
Reality Check: Not the Norm
However, such performance is an exception. Over ten years (2009-2018) hedge funds delivered an average annualized return of 6.09%, significantly less than the S&P 500’s 15.82% average yearly return in that same period. Instances of outperformance are rare, raising critical questions about the industry’s general claim for 2 and 20 fees.
Berkshire Hathaway’s Warren Buffett estimated in 2017 that the financial “elite” have inefficiently spent over $100 billion in aggregation searching for superior investment advice over a decade. Thus, the real billion-dollar question is whether most hedge fund managers achieve returns justifying their fee structure.
The Changing Face of Two and Twenty
Persistent underperformance and high fees have caused $94.3 billion in net withdrawals from hedge funds since 2016. However, hedge funds’ AUM saw an upward trajectory of $78.8 billion in the first quarter of 2019, reaching a global tally of $3.18 trillion, nearly closing in on the 2018 peak of $3.24 trillion.
Adapting pressure from increased market participants — now numbering over 11,000, down from fewer than 1,000 three decades ago — has squeezed fees lower. Today, typical charges are 1.5% for management and 17% for performance, a slight reduction from historical norms of 1.6% and 20%, respectively.
Additionally, political forces contest the income classification of performance fees for tax purposes. While the 2% management fee is taxed as ordinary income, the 20% performance fee benefits from the capital gains tax rate of 23.8%, lower than the 37% top ordinary rate. Efforts to reclassify these earnings as ordinary income continue to stir legislative debate.
An Illustrative Example
Let’s assume a hypothetical hedge fund, Peak-to-Trough Investments (PTI), with $1 billion in AUM at the start of Year 1 and observe its fee calculations over three years based on the Two and Twenty model:
Year 1:
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Starting AUM: $1,000M
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Ending AUM: $1,150M
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Management Fee: 2% of year-end AUM = $23M
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Performance Fee: 20% of fund growth ($150M) = $30M
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Total Fees: $23M + $30M = $53M
Year 2:
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Starting AUM: $1,150M
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Ending AUM: $920M
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Management Fee: 2% of year-end AUM = $18.4M
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Performance Fee: None (fails to exceed $1,150M high watermark)
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Total Fees: $18.4M
Year 3:
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Starting AUM: $920M
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Ending AUM: $1,250M
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Management Fee: 2% of year-end AUM = $25M
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Performance Fee: 20% of growth above high watermark ($100M) = $20M
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Total Fees: $25M + $20M = $45M
With this Three-year exercise, PTI showcases how high watermark provisions ensure performance-based payouts are predicated on superior management, delivering returns justifying the Two and Twenty fee model.
Related Terms: Hurdle Rate, High Watermark, Assets Under Management, Carried Interest, Quant Fund.
References
- Bloomberg. “The Best-Paid Hedge Fund Managers Made $7.7 Billion in 2018”.
- Berkshir Hathaway Inc. “To the Shareholders of Berkshire Hathaway Inc”, Page 1-17.
- U.S. Senate. “SENATOR BALDWIN AND REPRESENTATIVE PASCRELL REINTRODUCE TAX REFORM TO CLOSE TAX LOOPHOLE FOR MILLIONAIRES AND BILLIONAIRES ON WALL STREET”.
