Hedge Funds Cut "2 and 20" Pricing

For many years, hedge funds charged a baseline 2% and took a 20% cut of gains, because "it’s always been that way." Now, finance news is waking investors up to the possibility of alternatives.

Jan 7, 2014 at 10:24AM

Hot news from the finance industry shows that the monolithic fee structures of large hedge funds appear to be cracking. Under pressure from investors, these investment funds are reconsidering what used to be an industry standard called "2 and 20."

The 2 and 20 pricing model was, up until this fall, a pretty universal fee structure for hedge funds. Some experts cite the early millennial tech bubble as an event that helped to entrench these pricing models in the vocabulary of the average fund-manager.

What is "2 and 20?"
Essentially, hedge funds often charge investors standard fees of 2% for asset management. In addition, they ask for 20% of investment profits.

In exchange, hedge funds are supposed to offer advantageous investment opportunities through models like diversified risk, automated trading strategies, and the support of large asset pools. However, investors have been questioning this conventional wisdom for decades, as study after study shows that hedge fund managers have trouble beating simple investments in major indexes like the S&P 500 or the Dow Jones Industrial Average.

Tear down this wall!
Today, reports from all over the world of finance are showing investors haggling for lower hedge fund fees and getting satisfaction. A September Wall Street Journal report shows an average of about 18.3% for hedge fund performance fees and indicates that the standard 2% charge for asset management has shrunk down to about 1.6%. Other coverage from aggressive Wall Street/Main Street reporting icons like Matt Taibbi of Rolling Stone shows that investors and others are questioning a model that really provides a good pricing cushion for fund managers, rather than a competitive model for investors.

Other industry responses
Commentary on the current changes in hedge fund pricing models runs the gamut. Some argue that these cracks in the 2 and 20 model were inevitable, while others have firmly defended the traditional pricing.

A Nov. 4 Barron's article by Brendan Conway posits that part of the emerging downward fee pressure owes to the fact that there are so many hundreds of hedge funds out there competing for investor cash.

"It's just math that the number should come down," writes Conway.

Still, what's showing through in other opinions, and even in Conway's coverage, is that some hedge fund firms may preserve 2 and 20 pricing because they don't "need" new investors and the prestige of their brands support what they charge.

Veryan Allen goes further on this Hedge Fund blog, comparing high-fee hedge funds to Michelin star restaurants, and discount-offering firms to McDonald's.

While it may be true that some firms are operating in niche markets that support higher fees, it's also true that in a world of accessible digital brokerage accounts, new generations of investors are tired of paying a lot for someone else to manage their money. Furthermore, the 2008 crash led a lot of IRA and 401k account holders to look critically at all kinds of traditional "buy and hold" models. What the crises and the attendant Dow Jones volatility seemed to show hard-working families was that capital gains may necessitate a strategy where the individual investor's finger is always on the "sell" button, and traditional hedge funds don't usually offer that kind of model. The "trust me" approach is very 1990s.

Do hedge fund fees make a difference to small investors?
Relatively speaking, not many individual family investors are deeply tied to hedge funds. Experts point out problems with access to hedge fund investment opportunities, including minimum contributions, low-profile advertising, and various SEC rules. However, some individual investors with a relatively low net worth do want to get involved with hedge funds, either to diversify their portfolios or to automate some of the gains they hope to make in reviving markets.

Even small-time investors with capital assets in the tens of thousands can take comfort in pricing changes that put the investor in the driver's seat and promise better opportunities for higher-yield portfolios that don't suffer from "fee bloating." Rather than getting bled dry by the various strings attached to an investment, big investors like pension fund managers and small, family investors can get more by pursuing capital gains meant to support family finances and help the average worker.

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4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

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KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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