Why Charge Two and Twenty? Because Somebody Will Pay It
By the BrainSnail editorial team. How these articles are written and checked, and how to tell us when one is wrong.
The traditional charge of two per cent of assets each year plus twenty per cent of profits is enormously expensive and has been remarkably durable. The arithmetic of who gains is worth doing.
What the two parts do
The annual charge is levied on the total amount managed regardless of performance, and it exists to pay salaries, premises, data and systems, which are real and substantial costs. The performance charge takes a share of the gains, on the reasoning that it aligns the manager's interest with the investor's, since the manager profits only when the investor does. Those two components pull in different directions. The annual charge rewards gathering as much money as possible, since it scales with size regardless of results, while the performance charge rewards taking risk, since the manager shares the gains and not the losses.
The mechanisms meant to correct that
Several provisions were added to address the obvious problems:
- •A high water mark, so losses must be recovered before charges resume
- •A hurdle rate, so only returns above a threshold attract the charge
- •Manager investment alongside clients, so losses hurt them too
- •Lock-up periods preventing withdrawal, which cuts both ways
- •Clawback of charges paid on gains later reversed, in some structures
- •Longer measurement periods, so one good year does not pay out fully
Why the arithmetic is worse than it looks
Charging on gains without sharing losses produces an asymmetry that compounds badly over time, and a simple illustration makes it clear. A fund that gains fifty per cent one year and loses thirty the next has produced a small gain overall for an investor paying no charges, and one that pays a fifth of the good year's gain and receives nothing back in the bad year ends up behind. Over a long period the annual charge alone consumes a large share of the total return, since two per cent of a growing balance every year compounds into a very substantial figure. Studies of aggregate industry returns have found that the majority of the gross gains over long periods went to managers rather than investors.
How the charge is actually calculated
The mechanics are less obvious than the headline pair of numbers and the details change the amount substantially. The annual charge is usually taken monthly or quarterly on the value at that point, so it rises automatically as the fund grows and is taken whether or not the year is profitable. The performance charge is generally assessed annually and crystallised at the year end, at which point it is taken in cash or converted into units. Because it is assessed for each investor separately against their own entry point, two people in the same fund can pay very different amounts in the same year, and somebody who invested after a fall may pay on a recovery that leaves earlier investors flat.
Why it has persisted and what changed
The charge has come under real pressure while proving harder to dislodge than expected. Average levels have fallen, with surveys finding figures closer to one and a half and seventeen than to the traditional pair, and large investors negotiate individually. Money has moved towards index funds charging a small fraction of a per cent, which has forced the whole industry to justify itself. Against that, genuinely scarce capacity commands what it likes, and the most sought-after managers charge far more than the traditional rates and turn money away. The persistence is partly explained by the difficulty of telling skill from luck, since an investor who cannot distinguish the two cannot confidently refuse to pay.
The takeaway
An annual charge on assets rewards gathering money regardless of results, while a share of profits rewards taking risk, since gains are shared and losses are not. High water marks and hurdle rates were added to correct that. A fifth of a good year with nothing returned in a bad one leaves an investor behind after a round trip, and the annual charge compounds heavily. Average rates have fallen while the best managers charge more.