The history of hedge fund fees begins at sea. Well, not quite. It all started in 1949 at A.W. Jones & Company, the world’s first hedge fund, where its namesake founder Alfred Winslow Jones drew inspiration from seafaring Phoenician merchants who kept a fifth of profits generated from successful voyages. These ancient nautical tales led to the 2-and-20, one of the more familiar fee structures in the alternative investing world, though its usage has waned over time.
Hedge fund fees have evolved significantly over the last ~70 years, with the last decade in particular illustrating the most drastic change in fees as firms seek out new money after periods of mediocre growth. In this article, we will explore the anatomy of a hedge fund fee, learn about common fee structures, and understand how to calculate a fair fee. Let’s begin!
Fee Structure Components
Hedge fund fee structures are composed of two distinct parts: the management fee and performance fee. While the management fee is more or less fixed, the performance fee can include additional provisions such as a high-water mark or hurdle that gates the performance fee from distributing for poor performance. Let’s dive into the components below.
Hedge fund management fees are an annual, base fee charged on the number of assets managed by a firm, deducted on a monthly or quarterly basis. With a general range between 1% to 4%, these fees are used to cover administrative and operating costs for the investment firm. While more recognized firms may command a higher percentage of net asset value (NAV), management fees are decreasing across the board and even into the sub-1% range.
Also known as an incentive fee, hedge fund performance fees can have an even wider range of 10% to 40% and are intended to align the interests of the fund manager with the investor. Similar to management fees, figures have declined significantly over the past decade. Whereas the majority of hedge funds were charging 20% and above in the early 2000s, more than 40% of hedge funds now offer fees below the traditional 20% rate.
A high-water mark, also known as a loss carryforward position, measures the highest net asset value that an investment fund or account has reached. For fee arrangements that include a high-water mark provision, the manager must get their fund past the mark to receive a performance bonus. The provision is designed to ensure that investors only pay incentive fees on profit.
Hurdle rates set a minimum return rate that a fund or account must reach before it collects incentive fees. Soft hurdle rates charge a fee based on annualized return while hard hurdle rates only charge on daily/monthly returns above the set minimum. Both high-water marks and hurdle rates can be included in a hedge fund fee arrangement, which would require a fund or account to meet both thresholds before any incentive fees are collected by the manager.
Typical Fee Structures
Fees for alternative investment management vary widely from firm to firm, fund to fund, and even by share class. While we can’t possibly list all the variations, two fee models take up the most talking space: the traditional 2-and-20 and the 1-or-30.
The “two and twenty” is the standard fee structure in the alternative investment world, requiring a 2% management fee and 20% incentive fee with or without any additional performance provisions. The performance fee was set in place since 1949 by A.W. Jones, though the management fee - initially 1 point - rose to 2% in the early 1990s. This model dominated the industry throughout the 90s and 00s, but has come into question as a result of liquid alts’ deteriorating returns and increasing correlation to equity markets.
Critics of the 2-and-20 fee structure cite issues with the high management fee, which rewards fundraising over performance. These critical voices along with declining returns across the board have stimulated firms to react, reducing management fees in a bid to attract clients back into the fold.
The 1-or-30 fee structure is a newer approach to hedge fund fees, originating from Albourne Partners’ partnership with the Teacher Retirement System of Texas (TRS). As stated within a 2018 Albourne case study of the fee model, the 1-or-30 was developed to let investors keep 70% of the alpha generated by the manager.
The key operator in this structure is or. Whereas the 2-and-20 charges both the management and performance fee - all hurdles and high marks aside - the 1-or-30 has managers trade in their 1% management fee for a 30% performance fee of alpha when the latter is greater. There are some exceptions to this rule, but in general, the goal is for a manager to receive a predictable management fee revenue stream while the investor retains 70% of alpha.
Calculating Hedge Fund Fees
Each firm has its own nuanced approach to calculating fees while others are content with using off-the-shelf models such as the 2-and-20 or 1-or-30. Like the 1-or-30 model, our approach attempts to ensure the investor only pays fees for the value they receive. However, since fee structures are determined before any dollars are invested, the framework gauges not only how much value the manager brings, but the likelihood that this value will be sustained. We estimate the fees a return stream deserves based on a few simple criteria: Sharpe ratio, correlation to benchmark, annualized volatility, track record length, and allocation size.
To learn more about our methodology on fair investment fees and to generate your own fair fee, check out our investment fee calculator, Fee-Fi-Fo-Fum.