The Performance-Fee (2 and 20) Structure — How Do Hedge Funds Get Paid?
The hedge-fund fee that "takes 20% of the profit" — why is it so expensive? And this structure also contains devices that protect investors.
What Is "2 and 20"
"Two and twenty" is the traditional hedge-fund fee structure.
The front 2 is the management fee, taken every year at 2% of assets under management (AUM) regardless of performance. It is the portion that covers the fixed costs of running the fund.
The back 20 is the performance fee, in which the manager takes 20% of the profit earned. The remaining 80% is the investor's share. It is a device that gives the manager the incentive to generate returns.
"2 and 20" is only a symbolic benchmark; recently it has fallen due to fee competition. According to industry data (HFR), the average, which was close to 2 and 20 around 2008, is tallied to have come down to about 1.4% management fee and about the 16% range for performance fee around 2023.
The High-Water Mark: Recover Losses First
The performance fee comes with an important device called the high-water mark. It is a rule that a performance fee is taken only on "new profits" that exceed the past peak.
For example, suppose a fund rose from 100 to 120, fell to 90, and then rose again to 110. Since it has not yet recovered the high-water mark (120), no performance fee is taken over the 90→110 range. Only after losses are recovered first can a performance fee be charged again.
The high-water mark protects investors by preventing a manager from double-charging a performance fee through a mere "rebound" after a loss.
The Hurdle Rate and the Weight of Costs
Some funds also set a hurdle rate. It is a method where a performance fee is taken only on the excess above a minimum benchmark return (for example, a certain interest rate). It is a device that prevents charging a fee by counting even a basic interest-level return as performance.
Even with such devices, the performance-fee structure carries a heavy cost burden. Because the larger the profit, the larger that 20% becomes, in a good year the difference between the investor's and manager's shares is considerable. You should also remember that not many funds consistently generate excess performance large enough to offset high fees.
Frequently Asked Questions
Q. Does a performance fee align the interests of the manager and the investor?
To some degree, yes. Since a performance fee is earned only when there is a profit, there is an incentive to manage diligently. However, the 2% management fee is taken even in a loss, so it is not perfectly aligned with performance. The high-water mark and hurdle rate are supplementary devices that narrow this gap.
Q. Will ordinary investors ever pay this fee?
Hedge funds are generally for high-net-worth or professional investors, so it is rare for ordinary individuals to encounter them directly. However, some private-placement or alternative-investment products have a similar performance-fee structure, so you must always check the fee items in the product prospectus.
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