When one thinks hedge fund fees, the phrase “2 and 20” — meaning a 2% management fee and 20% performance fee — usually comes to mind. This wasn't always the case.
In the 1980s, “1 and 10” was not atypical. As more capital came into the space, however, fees initially rose to 1.5/15 and eventually to 2/20. Investors accepted the inertia of rising fees because net returns were still in the midteens and, on a risk-adjusted basis, still compelling compared to long-only investments.
Average hedge fund returns have since declined, yet fees, like an object thrown into space, have continued to levitate without gravity to pull them down. This is now changing as more investors realize the 2/20 structure doesn't make sense at today's return levels. Annual returns of the HFRI Fund Weighted Composite index have diminished to around 5% today from about 20% two decades ago. At this level, less than half (about 48%) of the returns the manager generates go to the investor under a 2/20 fee structure.
Disappointingly, we believe many investors have reacted to this inversely correlated relationship of fees and returns with a suboptimal solution. Many have simply redeemed from their hedge funds and redeployed the capital into passive strategies. On the surface this decreases overall fees. Below the surface, this represents a shift of portfolios out of alpha, making them more reliant on beta and removing the downside risk protection offered by active management and hedging.