The “2 and 20” Fee Structure

Not satisfied with traditional management fees of 0.2 to 1 percent, the Street has engaged in all manner of financial engineering, creating an array of “new” investment vehicles packaged under various names. These vehicles promise great returns, which allow them to charge a 2 percent management fee and a 20 percent carry fee. While this has been a terrific deal for the investment managers, the promise of these funds rarely comes to fruition for the investors.

The poor returns to investors from hedge funds are documented in Simon Lack’s recent book[1] where he states that “if all the money that has been invested in hedge funds had instead been put into US Treasury bills, the results would have been twice as good”.  Lack writes with authority because he invested in hedge funds for J.P. Morgan for many years, providing the bank’s capital and endorsement (!) to new funds in exchange for a share in the lucrative fees charged to later investors [2].

A well researched academic paper of January 2011[3] documents that “dollar-weighted returns (to investors) are of the magnitude of 3 percent to 7 percent lower than corresponding buy-and-hold returns (reported by the fund industry)”.  The authors find that the real alpha of hedge funds for investors has been close to zero.  The paper’s conclusions suggest that hedge fund investors take higher risk and earn lower returns than previously thought, for fees that can be ten times higher than traditional fees.

With the generally poor results of hedge funds and the often disappointing results of private equity funds, the investment management industry continues to look for new ways to replace the erstwhile lucrative fee generated by these products, the latest being Impact Investment Funds[4].

While ‘top quartile’ managers earn their fees, the number of funds that can maintain this classification for more than three years running is minute. Investors need to consider the impact the fees have on fund returns, particularly as we have entered a period of low market returns.

January 2012


[1] The Hedge Fund Mirage, John Wiley and Sons, 2012

[2] Financial Times, December 29, 2011

[3] Ilia Dichev of Emery University and Gwen Yu of Harvard University, Higher Risk Lower Return:  What hedge fund investors really earn, Journal of Financial Economics 100 (2011), pages 248 to 263

[4] J. P. Morgan, Insight into the Impact Investment Market,  December 2011