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Fund Management Fees - "Two and Twenty"

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I don't want to focus on fees to the exclusion of all else - our main focus at Fundsmith is on delivering superior performance. However, we would like to point out the very meaningful drag that fees and charges have on investment performance.

Two and twenty is the standard fee formula for the hedge fund industry.

It is unsupportable.

I am not so much shocked, as flabbergasted by the number of people who do not realise the impact of these fee structures on returns. I am not talking here about the fact that such performance fee structures clearly led many fund managers to gear up their funds as much as the credit bubble allowed and to place bets which many in Las Vegas would regard as outrageous, knowing that they had little or no downside and 20%+ of the upside.

I have had discussions with numerous professionals in sophisticated jobs in the investment industry who are either unaware of, or who disbelieve the mathematics of what I am about to demonstrate.

As you are aware, Warren Buffett has produced a stellar investment performance over the past 45 years, compounding returns at 20.46% pa. If you had invested $1,000 in the shares of Berkshire Hathaway when Buffett began running it in 1965, by the end of 2009 your investment would have been worth $4.3m. That's because Buffett runs Berkshire Hathaway as a company in which he co-invests alongside his investors.

However, if Buffett had set it up as a hedge fund and charged 2% of the value of the funds as an annual fee, plus 20% of any gains, of that $4.3m, $4.0m would belong to him as manager and only $300,000 would belong to you, the investor. And this is the result you would get if your hedge fund manager had equalled Warren Buffett's performance. 

Conclusion: Two and twenty does not work. That does not mean that 1.5% and 15% is OK, or even 1% and 10%. In my opinion, performance fees do not work. They extract too much of the return and encourage risky behaviour. The only way to focus your fund manager on performance without gifting him or her most of your returns is to ensure that he or she invests a major portion of their net worth alongside you in the fund and on exactly the same terms.