You will mostly hear the phrase ‘two and twenty’ alongside hedge funds. Hedge funds, unlike mutual funds, take investing to a more aggressive level. They have a higher risk potential, yet they work to minimize investor risk as much as possible.
This is why they may be considered a more audacious investment option. They are, therefore, not advisable for risk-averse investors.
The ‘two and twenty’ compensation is what and how fund managers are paid.
Who is a Fund Manager?
A fund manager, hedge fund manager, or fund trader can either be a financial institution or an individual tasked with overseeing every operation concerning the fund. The core character traits a fund manager should have include foresight, curiosity, confidence, courage, focus, intellect, and a risk-tolerant attitude. They should know when to pull the plug, when it’s best to invest, and how best to leverage without adversely affecting the investment’s performance.
While fund managers can be as aggressive and tactile as need be in making serious business decisions and creating business models, they also have the difficult task of ensuring the lowest possible risks and the highest possible returns.
Some of the most popular fund managers are Jim Simmons, Ken Griffin, Ray Dalio, and Renaissance Technologies. Jim Simmons is the founder of Renaissance Technologies. In 2021, Jim took home a whopping $3.4 billion. Israel Englander came a close second, with about $3.1 billion in the bank. Hedge fund managers are rewarded handsomely for their work.
Now, let’s get to the main issue. What is the ‘two and twenty’ compensation, and how does it work?
What is ‘Two and Twenty’?
The numbers represent percentages that should be paid out to hedge fund managers and other private investment funds. While the two are fractions of a whole, the denominator differs, as we shall see in more in-depth definitions below.
What is ‘2%’?
For all intents and purposes, we shall use a universal example that shall be used for the entirety of this article. Assuming you want to invest $5 million in your hedge fund of choice. The fund’s compensation structure uses the two-and-twenty style.
Now, 2% of $5 million is $100,000. This 2% shall go to management costs such as taking care of employee salaries, rent for office spaces, and general overhead expenses.
The 2% amount is paid to the fund manager whether or not the investment makes a profit. The fund managers act as the investment vehicle’s driver, and since the vehicle was driven, even if it ended up incurring a loss, it still needed fuel. This fuel translates to the mandatory 2%.
Note that this percentage is calculated against the total assets being managed and not on the performance of the investment. Therefore, the 2% will be fixed as long as the original assets remain unchanged.
What is ‘20%’?
Assuming further that your investment made a 40% return, this would mean that your gain would be $2 million, which consequently means that your investment is now worth $5.5 million. Your fund manager should earn 20% of this gain as ‘compensation.’ This is their pat on the back for ensuring a successful investment.
In this case, your fund manager will earn 20% of the gain, which is $500,000, making it $100,000. This compensation style works in a 4:1 ratio system, regarding the investor to fund manager. So that if an investment placed in a hedge fund using the ‘two and twenty’ system earns a profit, the investor takes four-fifths, while the fund manager takes a fifth.
The 20% is termed the performance fee, and unlike the 2%, it is only charged on the gain and not the total investment. Still, earning 20% as a fund manager is very lucrative and truthfully sets them in the same bar as the investment partner.
To check the fund manager’s cut, certain funds will require that the 20% is only charged on returns above a specified threshold, specified as a percentage. If the investment returns income more than this percentage, say 8%, the manager can take their 20% cut. This rate is called the hurdle rate.
2% and 20%
The investor will now have to pay the 2% management fee and the 20% performance fee cumulatively, reducing their earnings. In this case, adding the 2% and 20% fees, that is, $100,000 and $500,000, makes $600,000.
The investor will have to pay the fund manager, either an individual or a financial corporation, the entire $600,000 as compensation. Since they had made a 40% gain, increasing the investment to $2 million, the investor will retain $1.4 million, while the manager will take home $600,000.
Of course, the two and twenty fee rate will ultimately reduce the percentage return on investment. Since now the investor earns $1.4 million out of their original $5 million investment, the return on investment will be 28%, down from the 40% gain.
However, remember that the denominators for two and twenty are different, so we cannot generally assume that the fund manager takes the difference, which is 12%.
What if the returns are negative?
Another way to put this is: what if the investment suffers a loss? Will the fund manager still receive their two and twenty? The ‘two’ is constant, fixed, and a flat-rate. It does not consider the investment’s performance at all. So the ‘two’ is guaranteed.
It is also fairly simple for the ‘twenty’ aspect. The investment did not earn a profit, meaning that the performance was negative. The ‘twenty’ percent charged on performance works only for profits and not for losses, so it will not be charged if there is a negative return.
So, what really is the purpose of ‘two and twenty’?
Fund managers, just like any other working individual out there, have to protect their finances. The 2% works as security so that they are guaranteed a salary. The 20% works as an encourager of sorts since it works like a commission; the more the investment earns, the more they earn.
The 20% is where tax questions may arise: is it income or capital gains? Tax authorities treat it as capital gains rather than income earned. Therefore, fund managers pay less tax for their 20% than if it was considered as income.
