Friday, 23 June 2017

Investopedia: What does 'Two And Twenty' mean?

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Two And Twenty

What does 'Two And Twenty' mean

Two and twenty is a type of compensation structure that hedge fund managers typically employ in which part of compensation is performance-based. This phrase refers to how hedge fund managers charge a flat 2% of total asset value as a management fee and an additional 20% of any profits earned.

BREAKING DOWN 'Two And Twenty'

The 2% management fee is paid to hedge fund managers regardless of the fund’s performance. A hedge fund manager with $1 billion of assets under management (AUM) earns $20 million even if the fund performs poorly. The 20% profit fee is only paid once the fund achieves a level of performance that exceeds a certain profit threshold, typically around 8%. Some investors, who have never paid the 20% fee because there haven’t been any profits, consider the 2% management fee to be too high relative to the overall performance of many funds.

Famous value investor Warren Buffett has opined in a letter from February 25th, 2017 that " My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative." According to Buffett, very wealthy investors are accustomed to superior service and products in other areas of life, and they mistakenly think superior products and services are also available in financial services, which in his view is a mistake. They end of wasting trillions of dollars on overly complex and ineffectual hedge fund strategies. (See also: Warren Buffett's Annual Shareholder Letter for 2017.)
When High Fees Are Justified

One the world’s most successful hedge funds since 1994 has been Renaissance Technologies, led by Jim Simmons, a former NSA code breaker. At $65 billion in AUM, his fund generates $3.2 billion in annual management fees. Because of his remarkable outsized returns over the years, he also charges a 44% profit fee. It is estimated that his hedge fund returned an average 71.8% between 1994 and 2014. The fund's worst performance between 2001 and 2013 was a 21% gain. When asked by investors why his profit fee is so high, he responds by telling them they can leave if they want – but few do.
No Longer Two and Twenty

Due to their underperformance or inconsistent performance, many hedge fund managers have come under pressure to reduce their fees. Investors have been redeeming assets with poor-performing hedge funds at a record pace, with a large portion being reallocated to larger funds with stronger track records. To stop the bleeding, hedge fund managers have been complying. In 2015, the average fee arrangement stands at 1.5% of assets and 17.7% of profits. However, the top-performing hedge funds still charge 20% or more.

Investors are not the only ones complaining about high profit fees. Hedge fund managers are also coming under pressure from politicians who want to reclassify the profit fees as ordinary income for tax purposes. As of 2016, their profit fees, also referred to as carried interest, is classified as capital gains, which are taxed more favorably. Fund managers contend that carried interest is not a salary, but that it is an at-risk return on investment payable based on performance.
Performance Fee
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A performance fee is a payment made to a fund manager for generating positive returns. The performance fee is generally calculated as a percentage of investment profits, often both realized and unrealized. It is largely a feature of the hedge fund industry, where performance fees have made many hedge fund managers among the wealthiest people in the world.
BREAKING DOWN 'Performance Fee'

The basic rationale for performance fees is that they align the interests of fund managers and their investors, and are an incentive for fund managers to generate positive returns. A "2 and 20" annual fee structure - a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits - has become standard practice among hedge funds. Critics of performance fees, including Warren Buffett, opine that the skewed structure of performance fees - where managers share in the funds' profits but not in their losses - only tempts fund managers to take inordinate risks to generate high returns.

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