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28 September 2010


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I am terribly sorry, Terry, but your maths on the 2/20 is completely wrong (judging from the underlying spreadsheet).

As an investment professional you would know that in a standard private equity model:
a) management fee is charged on initial amount invested through the life of the founds (let's say 7 years based on a typical 5 year investment period and 5 year realisation period). That is 2% on 1,000 in your example for the first 7.5 years, not 2% on an opening balance every year;
b) Likewise, the 20% profit share is charged on realised gains, i.e. the gain between the opening 1,000 and the closing amount at the end of the fund life (for simplicity purposes, 7 years again).

Correcting for the above changes (and the wrong calculation of the investor's value in the last column), produces an annualised post management fee return over 45 year period of 17% or $1,040,722 ending balance. Far greater than the misleading $400,000 in your example.

Jestyn White

The 2 and 20 is stunning. I'm afraid my first reaction was that your spreadsheet had to be wrong. Of course on inspecting the logic, the sheet is correct. I guess the disparity is because the manager isn't paying 2+20 on his co-investment.

Of course, in reality, the fund manager probably takes his 2 and 20 out to pay expenses and his bonus, rather than leaving it invested, so neither side ever notices what's happening...

Terry Smith

KaKTy3 - I shouldn’t have included private equity in exactly the same way as hedge funds and have changed the post accordingly. However, 2 and 20 calculated as I have shown it is still the norm in the hedge fund industry and I assume you don’t disagree with the view that the split of returns which it entails is wholly unsupportable. And I’m not sure that leaving the investor with a whole $1,040,722 which your calculation shows out of a gross realised investment which would be less than the $4.3m my hedge fund example shows could be considered a reasonable split of rewards even if it is better. Of course, the private equity model suffers from some other problems. Like the fact that the realised gains are taxable so that you cannot achieve the same compounding effect, or that the some studies seem to show that the average private equity returns have underperformed the market indices, even with the risk of employing significant leverage.

Terry Smith

Jestyn, it is truly stunning. No one should give hedge funds money on this basis. You are right about the reason-the hedge fund manager does not suffer the drag of the fees so he just gets the full benefit of the compounding. However, the reality is rather different to what you envisage. Many successful hedge fund managers make so much money by this method that they end up constituting most or all of the fund as they return funds to the investors from whom they have levied these charges. They keep their money in the fund. Which raises another issue - reinvestment risk. If you are not only charged 2 and 20 but also have your investment cashed out by the manager when he has made as much money as he wants, you have reinvestment risk. You can't compound whilst you are uninvested. Anyway, whether the fund manager chooses to keep his money in the fund or not, it seems clear that the charges are an unreasonable division of the gains.


Hello. Can someone please tell me where to find the "underlying spreadsheet"? Thanks.

Terry Smith

Click on the graph to access the underlying data in an excel sheet.


Terry, how much of an effect does purchasing investment funds through companies such as Hargreaves and Lansdown or Fidelity, who offer discounts on both the initial investment fee and the annual management fee, have on any profits I receive?

Or, are the investment fund managers finding other ways to reduce any profits passed onto me as a customer?



I am not rallying against your point that one is unlikely to find a hedge fund manager who equals Buffett’s investment performance as measured by book value and the implication that some (not all) hedge funds managers may not be worth the performance fees they charge. However, I believe the way you have framed the argument against the structure of 2% / 20% does not accurately reflect the whole story.

A few technical points first.
1. Your model does not net out the previously paid management fees when calculating the performance fee (i.e. cell H10 in the data should be [=(F10-E10-G10)*0.2], and so on down the column.

2. Instead of using a high water mark in determining the performance compensation, you essentially utilize a claw-back (or negative performance fee), which unfortunately does not reflect the typical terms an investor might receive.

3. Your cumulative manager account amount is perhaps overstated, as the management fees would typically not remain invested in the fund and compound over time.

Technical points aside, and using your numbers as presented, the investor would have cumulative net income of 373,695, cumulative management fees of 95,955 and cumulative performance fees of 117,412. These numbers equate to gross income of 587,061, meaning that the investor has retained nearly 64% of the gross income generated by his investment over time. Such an operating margin compares favorably with other finance type businesses. For example, your own firm has had adjusted operating margins of roughly 18% a year over the last four years.

With regards to the manager account, and again using your numbers as presented, nearly 95% of the cumulative value of the account is attributable to the skill of the manager at compounding capital over time: 3,696,237 less management fees of 95,955 and performance fees of 117,412 equals 3,755,870 (94.6% of total). While these numbers clearly show why the hedge fund business can be so lucrative, it appears misguided to suggest that management fees and performance fees will necessarily equate to wealth for the manager. Positive investment performance is still the most important component.

As you will see if you adjust the numbers for the performance fee calculation mentioned in 1. above, the value of the investor’s account increases noticeably without significantly reducing the manager’s. This again speaks to the importance of compounding capital in the generation of the manager’s account.

Investment banks, trading firms, etc. generally take a minimum of 50% off the top in the form of compensation and that is regardless of what operating margin they ultimately deliver. An original allure of the hedge fund model was the alignment of the manager’s interests with investors. While asset gathering has perverted the original intention of the management fee (which likely should be reduced as assets under management increase), investors are not irrational to be willing to contingently spend a portion of their return should they receive positive performance. The problem, of course, is figuring out in advance which managers that are truly worth it.

boston hedgie

I have to agree with Mark. This analysis is incredibly flawed. I wouldn't comment except I've seen a few people point this article out to me.

Using a correct structure (20% carry net of a 2% management fee on average balances), the hedge fund will return 15% compounded vs. a Berkshire return of 20% compounded.

The investor will make $481k and the manager will make $231k, or a roughly 70/30 split. Nobody would be surprised at this structure (you'd instinctively guess the manager would take over a little over 20% given the management fee).

Again, as Mark points out, all your hyperbole is demonstrating is the difference in compounding. Fees are a meaningful and real drag on investment performance but the difference in 2009 balances has nothing to do with the avarice of the fund manager, it has to do with the incredibly powerful effect of compounding over long periods of time.

Anyone who's read a personal money management book and seen the "if you just saved $10 a month and invested it at 5% a year, you'd have so much at retirement!" chart should understand this.

Terry Smith

Mark, thank you for your comment. Even if I accepted your points 1 and 2 (and all we can say is what is typical) the idea that it is acceptable for the investor to retain just 64% of the “gross income” generated on his investment shows how far removed from reality this “industry” has become. The hedge fund business is indeed lucrative, as you suggest, precisely because the fee structure gives way too much of any gains achieved to the manager. With regard to your third point, in my experience quite a lot of hedge fund managers leave their fees in the fund (if they are any good at investing) and end up with a fund which only or mainly consists of their own money (which gives investors another risk - re-investment risk - you can’t compound in a fund you are cashed out from). In any event, the assumption that they can achieve the same compounding on those fees as they are achieving in the fund is hardly controversial.

Terry Smith

Boston hedgie, I presume your name demonstrates a certain bias in this matter. The analysis is not flawed. The math is simple. What is flawed is the fee model of the hedge fund world. Whatever rate of compounding you assume, too much of any gains achieved will accrue to the manager, and as I pointed out in my response to Mark, it is hardly controversial to assume that the manager retains the fees in the fund and they compound at the same rate.

What’s flawed is the hedge fund model, and not just because of the charging structure, although that has other problems such as encouraging managers to take highly leveraged bets on the “heads I win (through the performance fee) tails you lose” principle. The results delivered by the industry have hardly been sparkling and the industry’s inability to deliver returns irrespective of market direction would suggest that the original concept of a hedge fund developed by A W Jones has now largely disappeared and that the term only indicates a particular, and insupportable, charging structure.


Ok, so Terry makes his point with a worse case scenario, but the point that investors are being screwed over, still stands. The bank robber in court doesn't plea endlessly for a reduced sentence because he left some swag behind that he couldn't carry out.
Terry - I've been waiting for years for someone to come out of the pack and launch a new fund management model, so that I can invest in it (the company, that is) at an early stage. As an individual investor, will it be possible for me to be in at the start of Fundsmith and if so, how?

Simon Wallis

@herdshearer: surely you should be asking, "is it possible for me to invest in a hedge fund (the company, that is) and if so how? As for myself I will just be glad to invest in an actively managed fund where the principals take a symmetric risk alongside me (the fund, that is).


Indeed Simon, but for the long game Fundsmith has the chance to lead in a dramatic revolution that can turn the industry on it's head. At no other point in my lifetime has the environment been so contusive to such a revolution.

Norb Vonnegut

I think your analysis is right on the money, Terry. I especially like your response:

"Even if I accepted your points 1 and 2 (and all we can say is what is typical) the idea that it is acceptable for the investor to retain just 64% of the “gross income” generated on his investment shows how far removed from reality this “industry” has become."

The unfortunate reality, however, is that two-and-twenty won't change until clients take a stance. Thanks for the analysis.


There is nothing wrong with your calculation, Terry.

I have just checked it assuming £1000 invested in a fund growing at 20.46% pa and annual fees of (2+ 20.46 x 0.2), ie 6.o92% over 45 years.

My answer on the final result is 4.09 mln to the manager and 257,000 to the investor, a 94%/6% division. Incredible.

I used my own program which I have checked against the figures quoted by UT managers for their funds and also against calculators on various financial websites and its results agree perfectly.

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