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How “2 and 20” Fees Really Work

When people talk about hedge funds, whether it’s to mock their dismal results or just focus on the few good examples, the “2 and 20” term is often brought up. This refers to the fees that hedge fund managers are paid but it’s frequently used incorrectly.

The fee model is to pay the manager 2% of the portfolio value every year (a fixed fee) plus a variable fee that’s commonly explained as “20% of the profits” or “20% of the returns”. This makes it sound like a very bad deal since it’s not hard for a fund manager to earn an 8-10% return and no smart investor would pay an extra 20% of that.

The way it’s actually applied can be different for each fund. For example I’ve heard of funds where the extra fee is 20% of the returns above a specified benchmark, meaning the manager has to outperform the common stock index to earn more. This is a much more reasonable arrangement where the manager would need to beat the index by 10% to earn a total of 4% in fees. As long as the index is chosen well and represents the alternatives that the investors are considering, there is some alignment between the fund manager and the fund investors.

Other examples aren’t so good. I was analyzing the prospectus for a local “Labor-Sponsored Venture Capital Fund” the other day which allows residents of the province to invest in small local companies. It’s run by a local fund manager who have given themselves a 20% participation in the investment returns. They actually do get a full 20% of the returns for any individual investment that they make a profit from, with one of the few conditions being that the overall fund return is at least 1% higher than the 5-year average return on GICs (CDs for american readers) at a local credit union.

This is a weak incentive in two ways: (1) the threshold is too low; venture capital investments should not be comparable to GICs in any way, and (2) once that threshold is met the manager takes a cut of the full returns rather than just the excess returns. A smarter incentive would be for the manager to get 20% of any cumulative returns in excess of those that would be earned by investing in the TSX index.

When analyzing an investment it’s worth staying away from anything that is too generous in paying fees to the manager. For example the above-mentioned fund had 2 out of the last 5 years where investors earned approximately 0.02 – 0.1% and the manager earned 5.3 – 6.4% in the same year. In 4 of the last 5 years the manager earned more than the investors. That’s a clearly one-sided arrangement (and you can’t even buy shares in the management company to participate in their sweet deal). In other cases this can be structured so the investors get most of the benefits and the manager really has to do well to earn more.

However that still leaves one major risk. The managers get a part of any good performance, but if the fund loses money only the investors are harmed (and the manager could still earn a bonus if the fund does better than the index). This naturally encourages the manager to take bigger risks because their worst outcome is to “only” earn 2%. The best alignment of incentives happens when the manager actually invests a large part of their net worth in the fund so they are directly harmed by any losses.

The fund I analyzed is particularly amusing because it is eligible for a tax credit that is limited to an investment of $5,000/year per person. Because of this, no manager appears to have more than $40,000 in the fund so they are not exposed to serious losses. In comparison the management company earned over $9M for running the fund last year. In this case the incentive has unintended effects. I believe the managers could invest more, they just wouldn’t get a tax credit for it and they clearly don’t believe in the fund enough to do that.

To sum it up, when you make sure that you earn exactly the same as someone who is smart and experienced you have a chance of doing well. When they get paid differently from you, watch out!

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