Two and Twenty: Hedge Fund Fee Structure

Key takeaways

• “Two and twenty” refers to a common hedge fund fee model: a 2% annual management fee on assets under management (AUM) and a 20% performance (incentive) fee on profits above a benchmark.
• Variations exist by strategy; some funds charge lower management fees or lower performance fees.
• Performance features such as a hurdle rate and a high watermark control when performance fees are payable.
• While a few funds have delivered exceptional returns that justify high fees, on average hedge funds have struggled to consistently outperform broad equity indices, prompting investor outflows.

What is “two and twenty”?

“Two and twenty” (or “2 and 20”) is a fee arrangement widely used by hedge funds, private equity, and some venture capital vehicles:
* Two (2%) — annual management fee, typically charged on AUM to cover operating costs and portfolio management.
* Twenty (20%) — performance or incentive fee, usually charged on profits above a predetermined benchmark (a hurdle rate) or above the fund’s previous peak value.

How it works

Management fee:
* Charged regardless of performance; example: 2% on $1 billion AUM = $20 million per year.

Performance fee:
* Paid only when the fund generates profits above a hurdle rate or above the high watermark.
* Hurdle rate: a minimum return the fund must exceed before the incentive fee applies.
* High watermark: ensures the manager collects performance fees only on net gains that exceed the fund’s prior highest value, preventing fees on recovery from earlier losses.

Simple example

Fund PTI starts with $1.00 billion AUM.

Year 1
* End AUM: $1.15 billion (gain = $150 million)
* Management fee: 2% × $1.15B = $23.0 million
* Performance fee: 20% × $150M = $30.0 million
* Total fees year 1 = $53.0 million

Year 2
* End AUM: $920 million (loss)
* Management fee: 2% × $920M = $18.4 million
* Performance fee: $0 (high watermark not exceeded)
* Total fees year 2 = $18.4 million

Year 3
* End AUM: $1.25 billion
* Management fee: 2% × $1.25B = $25.0 million
* Performance fee: 20% × ($1.25B − $1.15B) = 20% × $100M = $20.0 million
* Total fees year 3 = $45.0 million

Are the fees justified?

Arguments for:
* Exceptional funds can generate very high risk-adjusted returns, making high fees acceptable to investors who receive outsized performance.
* For successful managers, fees can align their incentives with investors when performance-based charges dominate.

Arguments against:
* Many hedge funds do not consistently outperform broad market indices after fees.
* Empirical evidence has shown that, in aggregate and over long periods, hedge funds often underperform the S&P 500 on a net-of-fees basis.
* High fees together with mediocre net returns have prompted substantial investor outflows in recent years.

Fee variation by strategy

Fees can vary significantly across strategies:
* Some arbitrage funds may charge around ~1.4% management and ~19.6% performance on average.
* Long-biased funds often show lower average fees (e.g., <1% management and ~10% performance in some samples).
Fund terms are negotiable—larger or institutional investors often secure lower fee schedules.

Who can invest in hedge funds?

Hedge funds are typically available only to accredited or qualified investors. Common SEC thresholds for an accredited individual include:
* Earned income over $200,000 in each of the two most recent years (or $300,000 combined with a spouse), or
* Net worth over $1 million excluding the value of the primary residence.
Certain professional licenses and institutional qualifications can also qualify investors.

What hedge funds do

Hedge funds pool capital from accredited investors and pursue a wide range of strategies—long/short equity, global macro, event-driven, quantitative, arbitrage, distressed debt, etc.—with the goal of generating alpha (returns above a benchmark). They are generally less regulated than mutual funds and may use leverage, derivatives, and short selling to pursue returns and manage risk.

The bottom line

“Two and twenty” remains a recognizable industry standard but is not universal. The management fee (2%) is payable regardless of performance, while the performance fee (20%) is intended to reward managers for outperformance, subject to hurdles and high-water marks. Investors should weigh fee levels, historical net returns, strategy fit, and alignment of interests when evaluating hedge funds; for many investors, lower-cost, broadly diversified alternatives may offer more reliable net outcomes.