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In defense of 2&20

In Defense of 2&20



It is a widely held belief – at least among the pundits whose profession it is to infuse such beliefs into the larger community to the point that they become "widely held" – that the 2% management fee/20% incentive fee compensation model employed by most hedge fund managers fleeces the unsuspecting investor. I disagree. Let me explain why:

Let’s start by acknowledging that the best known hedge fund managers are incredibly, immorally and unconscionably overpaid. Their compensation has nothing to do with their contribution to the product, the process, society or the general welfare of anything. They were simply for the most part smart and, in all cases, lucky. Luck may favor the well prepared but it's still luck.

But let’s focus on the typical alt investment manager. Like many aspects of modern economic reality, the population of fund managers breaks out in a 99%/1% split, where the 1% makes it into the news when they corner a market or throw hissy fits at each other over some perceived infraction of Hamptons protocol or Manhattan penthouse terrace etiquette. The vast majority of fund managers are eking out a (often quite comfortable) livelihood doing what they love.

The typical fund manager is not running a vast empire. Median fund size in the HedgeAlytix universe is currently around $34 million although the heavy offset of the larger funds pulls the average fund assets up to around $87 million. In all, there are some 20,000 pooled vehicles globally chasing somewhat over $3 trillion, or an average fund size of $150 million; this is counting all the in-house or otherwise private capital essentially invisible to the outside world.

The reason for this is quite simple: starting up an alternative investment vehicle is an easy process. All you need is skill, experience, perspicacity – and access to money. Twenty years ago, when the industry was still young, most hedge funds started at the home office (or kitchen table) with assets provided by friends and family. Most still do, although many are fortunate enough to lock in promises of seed money from a pension fund or other small institution, typically in exchange for some form of side letter arrangement.

The 2% management fee for a $34 million fund will be $680,000. That would certainly cover the expenses of two or three employees but it must also support the entire undertaking, including legal fees, administrative and audit expenses, rent, insurance, data access and equipment, etc. It gets chipped away quite quickly.

A number of funds have attempted to institute a sliding scale of fees based on total assets. In most cases, these schemes fell apart in the implementation stage; more often than not they devolved into “retail” and “institutional” classes where lower fees were tied to higher capital contributions and/or reduced liquidity. The bottom line is that the change in actual results from a management fee dropping from 2% to 1.75% is insignificant to the investor while the difference in revenue received by the management company can be huge.

The 20% side of this fee structure is a different story. For example, one of the first successful commodity pool operators was Paul Tudor Jones, II. When he and his partners organized their investment vehicle, The Tudor BVI Fund Ltd, in (I believe) 1986, it was based on an annual management fee of 4% and a monthly performance allocation of 23% of trading profits (without a high water mark). Tudor made the news last May by announcing that it was reducing its performance fee down to 25%. The firm has over the past several decades grown to $11.6 billion in assets (which at their base management fee of 2.75% yields some $319 million annually before any performance-based allocation) and had increased its base performance allocation to 27% of profits. Just a quick jot on the napkin would reveal that if the Tudor fund(s) scratched out an industry average gain of 10% in 2014, that would have resulted in a payday of another $300 million or so. Of course, managed futures in aggregate lost almost 1% in 2015, so they would have only seen performance allocations in the six months where they gained, rather than lost, money; my understanding is that they still make monthly allocations and they still are not saddled with a HWM obstacle.

So performance fees can be difficult to justify, particularly for very large funds. However, if the payment is based on performance above a specified hurdle rate, then it can make sense for an investor. A rising tide raises all boats…

For a smaller fund manager, the ongoing management fee should pay the bills of the business and the performance fee is a bonus for doing a great job. If the allocation is based on returns above the investors’ expectations or requirements, then everyone is well served.