2 and 20 Hedge Fund Fees Explained: Worth it in 2023? (2024)

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Have you ever wondered how much it costs to invest with a hedge fund?

Everyone is looking to make a buck, and of course, the most powerful financial firms on the stock market are no different. 💰

These monolithic investment machines are designed like all other financial funds, whether they be index funds, mutual funds, or retirement vehicles. They all have one overarching mission: to return profits to their investors.

In this article, we will explore how hedge funds make money, and what that means for investors looking to use them. We will also see if their ludicrously high fees are worth the price, or if they cut into valuable returns.

Sound good? Let’s go! 🚀

What Does “2 and 20” Mean?🔎

The basic fee structure around hedge funds is known as 2 and 20. If you’re not sure what a hedge fund is, one of the most important factors involved is its fee structure. The numbers stand for the amount of money that investors have to pay to invest with the firm.

The 2 part of “2 and 20” is the basic percentage fee you pay for the service. Depending on the fund, this can be a fee of anywhere from 1% to 5% that investors pay every year for their money to be managed. But on average, it is close to 2%. If you have a $1,000,000 investment you will have to pay $20,000 each year for the service.

That may sound like quite a bit of money that the corporate overlords are extracting from investors—and compared to other kinds of funds, it is. Some index funds and Exchange Traded Funds have expense ratios as low as 0.2% and even down to 0%. If you are investing in a hedge fund, you will pay a premium, the bad news is the 2% fee isn’t the only expense.

The counterpart is the 20 side of the equation. 20 refers to a certain benchmark fee where the firm will take a 20% cut of the total growth of the fund if they meet performance goals. The 20% isn’t pulled from your account individually; instead, it comes from the total returns that all of the assets generated. This will lower the money returned to investors.

Understanding the 2 and 20 Fee Structure 💡

The 2 and 20 fee structure is how hedge funds make their money, but how much cash are these businesses raking in? Let’s look deeper at the way the structure works and some real examples.

The reason that hedge funds receive the 2% fee is so that the fund can continue to operate and cover its administrative costs even if the company has a bad year. These costs cover office space, salaries, and other overhead. Whether the fund performs above-average or it does very poorly, investors must pay this.

Because the funds are actively managed, their overhead is a lot higher than passively-managed funds and other simple investment strategies. Actively-managed funds require more effort and stock research than something like an S&P 500-tracking index. It is debated whether actively managed funds are much better than passively managed ones because after accounting for the additional fees, their returns are comparable. In 2020 they even underperformed the market.

While the 2% fee helps keep the doors open, the 20% is supposed to drive performance. The 20% fee is known as the hurdle rate. Depending on the hedge fund there are different metrics to determine success, but if a fund is successful, the managers are rewarded with 20% of the profits.

Some hedge funds also institute what is known as a high watermark clause. This means that the fund can only pay out the performance fee if they meet a goal that is higher than the last all-time high.

This high watermark clause helps prevent payouts when hedge funds perform poorly. For example, if a company loses 30% of its value one year, and then in the next year they return 20% profit, they won’t be paid the incentive.

Some of the largest hedge funds in the world are able to generate billions of dollars in profits just from their fees. These profits have caused many to ask if the 2 and 20 structure is too pricey. After all, if the investment firm is gaining billions of dollars, that is money that investors are missing out on.

Is the 2 and 20 Fee Structure Worth It? 💸

The 2 and 20 fee structure may sound extreme to some people, especially when compared to other average-performing index funds. The problem is that sometimes the fees are justified. It can be worth it to invest in one of these hedge funds to see significant returns.

But as with all investing, making above-average returns year over year isn’t easy. Amongst hedge funds, it definitely isn’t the norm. Oftentimes, a particular hedge fund will gain popularity because they show promising returns or solid performance history.

This attracts investors and grows the funds’ assets. The hedge fund may continue to outperform the market, but past returns do not guarantee future returns.

When these funds inevitably miss their performance benchmarks it can drive investors away. Whether the downturn comes from a failure of management or just a bad year of inflation investors are bound to withdraw. When looking at the performance of hedge funds over the course of many years, it becomes less clear why the fees are so outrageous.

If you compare the average performance of an actively managed hedge fund to a passively managed index fund, the difference is stunning. Even with record-breaking returns of 12.3%, they struggle to keep up with average market returns. Oftentimes, only beating the S&P 500 by thin margins if at all.

According to a report by Hedge Fund Research, Inc., the difference in returns between an S&P 500 tracking index and the average hedge fund is negligible; however, the hedge funds haven’t performed as well as the overall stock market for the past 8 years.

The HFRI Fund Weighted Composite Index measures all hedge funds with at least $50 million in assets under management. Compared to the S&P 500, the returns are close to the same.

Other Hedge Fund Fee Structures 👇

Although the 2 and 20 system is fairly popular amongst hedge funds, there are other kinds of fee structures that investors may prefer. Some of these structures help combat problems with poor performance while at the same time stabilizing a hedge fund by locking down assets.

Capital Lockup 🔒

Some hedge funds offer their investors significant discounts if they keep their money locked into a company for a long period of time. Typically these are between 5 to 10 year periods. Some hedge fund investment strategies require many years to meet their profit goals. Locking money up helps the fund maintain consistency.

Founders Shares 👨‍💼👩‍💼

When a hedge fund is first forming, the company will typically offer better deals to the first investors. This helps the fund build its assets quickly to generate greater returns. The fees normally roll down from 2 and 20 to something like 1.5 and 10. If you believe in the long-term growth of a fund, this can be a great way to increase your gains.

Milestones 🎉

While some hedge funds will charge 2 and 20 for all the money that is generated, other funds have clauses that limit the amount paid after a certain milestone is met. This might come into play if a company charges 2 and 20 on profits up to 20% but then rolls that back to something lower, such as 2 and 15 for profits greater than 20%.

Alternatives to 2 and 20 Hedge Funds ✅

Rather than padding the coffers of some giant company to meet average returns, you may be interested in simpler kinds of investing with less intensive fees and management styles. You can get to similar performance goals by using robo-advisors, minor money managers, or even just buying Exchange Traded Funds from your broker.

Any of these investment strategies can be as profitable as investing with a hedge fund. It’s important to find the investment style that fits your goals— for instance, robo-advisors can be an excellent way to consistently invest and meet retirement goals, while finding an ETF through one of the top stock brokers can give you more control over your money.

It can even be profitable to try managing your own portfolio—some of the wealthiest investors of all time have made their money picking their own stocks. Finding alternatives can end up making you money.

💰 Note: If you’re looking for a reliable passive investing solution that won’t cost you an arm and a leg, checking out the top robo-advisors for high-net worth investors can be a good option.

What’s the Downfall of 2 and 20? ⚠️

Because many hedge funds only produce lackluster results, investors have been withdrawing their money from the companies. This in addition to an astonishing number of new hedge funds opening year after year has created downward pressure on the 2 and 20 fee structure.

We are already seeing the 2% fee become less common, and the barriers for reaching the 20% performance incentive more difficult. All of this ultimately contributes to more profitable hedge funds for investors and less incentive for managers.

But while some funds are moving towards more reasonable fees, the most successful funds still charge extreme rates of 5% with performance fees of 44%. They are even increasing as profits continue to rise.

Conclusion 🏁

Now that you have the 2 and 20 system under your belt, you can decide whether a hedge fund is the best place to put your money. While some of the highest-performing funds can generate massive returns, it’s not clear if every management firm deserves their bloated fees. Whether you are investing in the S&P 500 or an average hedge fund, your returns will likely be the same.

If you aren’t interested in making the richest companies in the world even richer, then you may want to avoid these funds. But if you invest in the right company, you may see massive returns.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.