Two and twenty has long been the standard in the financial industry for hedge funds, venture capital funds, and other private investment funds. Alternate name: 2/20 For an example of how two and twenty works, imagine that you have $2 million to invest. You choose to place that money in a fund charging two and twenty. Over the course of one year, you’ll pay roughly $2 million x 2% = $40,000 for the 2% management fee. If during that year, the fund returned 20%, your $2 million would grow by $400,000 to $2.4 million. The fund’s manager would be entitled to 20% of the fund’s gain as a performance fee, which would translate into $80,000 (20% of $400,000) for you. So you’d end up paying a total of $120,000 ($40,000 + $80,000) in fees under the two-and-twenty fee structure. Net of the fees, your gain would be $2.4 million minus $120,000, or $2.28 million. Remember, the fund’s return was 20%, but after paying the fees, your $2 million has become $280,000, which is a gain of 14%. If the fund instead loses money—for example, losing 10% of its value—your $2 million would be eroded to $1.8 million. You’ll still have to pay the 2% management fee, which would amount to $80,000, leaving you with $1.72 million, or an equivalent 14% loss on your initial investment. However, in recent years, many have begun to question whether the typical two-and-twenty fee structure is reasonable or worth paying. According to a 2020 survey of hedge funds by Alternative Investment Management Association, the average incentive fee paid to hedge funds was 17.5% of annual profits.
How Does Two and Twenty Work?
The idea behind a two-and-twenty fee structure is that it incentivizes managers to perform well while providing guaranteed income to keep the fund running. The more the fund earns, the more the fund managers earn from their 20% cut of the fund’s earnings. At the same time, the 2% management fee provides a relatively stable income for the fund managers. For example, consider investing your $2 million in a fund that has a two-and-twenty fee structure, along with a hurdle rate of 8%. If in a given year, the fund returns 10%, you’d be on the hook to pay both the 2% management fee and the 20% performance fee; however, if the fund’s return is 7%, you’d only have to cough up the 2% management fee. One reason two and twenty has become popular among fund managers is its tax treatment. The 20% performance fee, or carried interest, is typically treated as capital gains rather than income, meaning it gets taxed at a lower rate. This lets fund managers pay less tax on the money they earn from managing their funds.
Alternatives to Two and Twenty
The primary alternative that investors have to invest in private funds and paying their fees of two and twenty is to invest in publicly available mutual funds and exchange-traded funds. Mutual funds and ETFs typically don’t charge performance fees or have carried interest. Instead, they have a lower fee based on the amount invested, called an expense ratio. In the case of some funds, especially passive index funds, the fees can amount to less than 0.10% per year, making them much less expensive to invest in. The drawback is that mutual funds and ETFs typically don’t use the complex and sometimes highly lucrative strategies employed by hedge funds and venture capital funds, which means they may have lower overall returns.
Incentivizes managers to make sure the fund performs well: Because managers get to keep 20% of the fund’s returns, they earn more if the fund earns more, giving them more incentive to invest well. Privately managed funds have more flexibility than public ones: Private funds, like hedge funds, have more freedom to invest using complex strategies, such as using derivatives, short selling, or venture capital.
Cons Explained
High fees can significantly affect overall returns: Investors pay 2% of invested assets and 20% of the fund’s returns in fees. To come out ahead compared to an ETF charging less than 1% annually, the private fund will need to significantly outperform the ETF.Privately managed funds with a two-and-twenty fee structure often have high minimum investment amounts: Private funds, like hedge funds, can sometimes require that investors have $1 million to invest before they can buy into the fund, which is out of reach for many investors.
Is Two and Twenty Worth It?
Whether paying two and twenty to invest in a private fund is worth doing is a question of the fund’s performance. Consider the example above. With a fund charging two and twenty, a 20% return on an investment of $2 million became a 14% return after fees. An investor who could find a cheaper investment charging less than 1% would earn more if that investment returned just 15%, three-quarters of the return the fund manager earned. According to a 2020 study, investors in hedge funds typically collected just 36 cents of every dollar earned on their invested funds after paying fees and other costs in the 22 years between 1995 and 2016. Researchers also established that the effective performance fee to hedge fund investors was closer to 50% instead of 20%. This means that these funds must greatly outperform publicly available funds to be worth investing in. Some investors may be able to earn higher returns after fees by investing without using private funds.
What It Means for Individual Investors
Many individual investors won’t be able to invest in hedge funds and other private funds because of their high minimum investment requirements. If you do have the opportunity to invest, consider how the fees will affect your overall returns and whether you can get better returns, after fees, by investing in less costly alternatives, such as index funds.
