Draft obit for 2020: 2-and-20 fee structures

December 28, 2012

By Neil Unmack and Richard Beales
The authors are Reuters Breakingviews columnists. The opinions expressed are their own. 

Anticipated publication around 2020.

The most surprising thing about the demise of two-and-20 hedge fund fees is how long it took. Neither losses in the 2008 credit crunch nor the feeble returns during the ensuing seven-year euro zone crisis did much to bring down the archetypal fee structure: 2 percent management fee and 20 percent of gains. Now, though, it can finally be said: two-and-20 is dead.

Back in September 2012, the average hedge fund still charged 1.6 percent annually in management fees and collected 18.7 percent of any gains, according to data provider Preqin. Through November that year, the average global hedge fund investor earned just 2.6 percent, according to the HFRX global index maintained by Hedge Fund Research. In 2011 investors lost nearly 9 percent. The average annual return from 2009 to 2012, supposedly recovery years following the losses of more than 20 percent in 2008, was a measly 3 percent.

A few investors – including huge institutions like California’s giant pension fund, Calpers – managed to negotiate better deals. More often, funds that did badly simply shut down, while investors often signed up for new funds at the usual fees in the hope that the high-return strategy so elegantly set out for them by the latest persuasive trading titan turned out to work.

And a few duff years did little to dent demand. Hedge fund assets reached $2.2 trillion by the third quarter of 2012, some 17 percent above the 2007 pre-crisis peak. By 2015 they were still rising.

Yet it now looks as if those traumatic years marked the beginning of the end for the image of hedgies as superhuman traders. Faced with unpredictable markets, heavy central bank intervention and increasing red tape, some managers simply gave up. Pioneer Stanley Druckenmiller closed his fund in 2010, noting tellingly that managing more than $10 billion didn’t allow him to make the kind of returns he wanted. Some others did the same or returned money to outside investors. A wave of insider-trading scandals further tarnished the sector’s image, casting doubt along the way about the legitimacy of some top managers’ returns.

It didn’t help that hedge funds were becoming an industry. After the 2008 collapse, regulators and investors alike watched funds more closely. Managers needed to have large businesses to justify the required information and compliance systems, and diverse ones to avoid concentrated risks that might scare cautious institutional investors like pension funds. As Druckenmiller had foreseen, big firms ended up making lower returns, on average. And for the fund firm bosses, management fees approaching 2 percent made a large-scale business a ticket to riches even without stellar returns.

Investors initially settled for modest returns during good years and capital protection in bad times. But then many realized that the two-and-20 fee structure was out of kilter. Pension fund managers’ own rising liabilities made them tougher in claiming a higher proportion of the investment returns on their money. The most sophisticated ones set up their own in-house managers, staffed with refugees from shrunken investment banks and unlucky hedge funds.

Now in 2020, there’s still a lot of money run by hedge funds. But there’s a clear bifurcation. It’s hard to distinguish parts of the industry from traditional asset managers like BlackRock and Fidelity – and those behemoths have snapped up some funds. In this branch, firms can still charge a management fee of 1 percent. But performance fees have shrunk to 5 percent or less, often after a minimum risk-free return is reached, in recognition of the more earthbound expectations investors now have of performance.

The other wing of the industry consists of hedge funds that have essentially gone back in time to something closer to the original concept – impressive returns in all market conditions, with fees to match as long as the returns are forthcoming. In the 1960s, Warren Buffett ran a fund charging no management fee but taking 25 percent of investment gains above a 6 percent threshold return.

In 2012 Guy Spier, whose $100 million-plus Aquamarine Capital Management has a class of shares that follows Buffett’s old structure, referred to the “microscopically small proportion of investment managers who decline to charge a management fee”. Eight years on, there are more of them, though it’s the harder and lonelier – if arguably the most investor-friendly – of the two hedge fund roads. Neither would look familiar to a manager who retired hugely wealthy in the early part of the past decade. But as places to invest, at least both now have fees that are a better fit.

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