Hedge funds typically earn income through a variety of fee structures charged to their clients. These fees are not only meant to cover fund administrative and operating costs, but also to reward employees and managers for providing positive returns to investors. The most common and well-known hedge fund fee structure combines both management and performance-based fees.
First, the “management” fee represents an annual, base fee levied on the amount of assets managed by a firm. This fee can represent anywhere from 1-4% of net assets, however 1-2% is the most common range. Thus, as an example, if a hedge fund has a management fee of 2%, then investors are charged $2,000 for every $100,000 invested in the fund, per year. However, rather than being levied on the investor as one flat charge, management fees are usually deducted incrementally, on a monthly or quarterly basis. These fees are traditionally used to cover fund administrative and operating costs, which may range from paying a full-time staff to renting office space to attending conferences.
The second common fee structure within the hedge fund industry is a “performance,” or incentive-based fee. Performance-based fees, on an ideological level, are intended to properly align the interests of the fund manager with investors. The fee, which represents a percentage of the year’s profits, is thus only awarded to the manager in the event that he provides positive returns to his clients. Performance fees typically range from 10-40%, however 20% appears to be the accepted industry norm. Often, these fees are allotted to firm employees and managers in the form of bonuses, used as a way to reward positive performance by managers on behalf of their clients. Hence, when a hedge fund’s fee structure is referred to as “2 and 20,” this means that it charges a 2% management fee and a 20% performance fee.