As hedge funds battle plunging equity markets, rising inflation, and large outflows, they are set to face another challenge next year — their so-called 2 and 20 fee structure.

The structure — charging a 2% management fee on total assets under management alongside a 20% performance fee on profits generated — has been used for decades across the industry.

But volatile market conditions and faltering performance could spark a challenge to the model.

“Many funds are likely to face challenges justifying their high 2 and 20 fees following a period of weaker asset returns. Those funds will either have to operate at a much lower cost or close,” says Bob Elliott, a former Bridgewater Associates executive who is now CEO at newly-launched hedge fund ETF Unlimited.

Elliott told Financial News that a vast majority of funds’ performance does not justify 2 and 20-type fees.

In the third quarter of 2022, hedge funds saw $26bn in net outflows, Reuters reported, citing Hedge Fund Research data. From January to September, the HFRI fund-weighted composite index, which tracks the performance of the world’s largest hedge funds, fell by 6.6%.

Investors will take a hard look at the fees they are paying and hedge funds are likely to face a challenging 2023, Elliott added.

“It was easier to hide those fees when all assets were going up, and much more difficult as performance dispersion increases,” he said. “Even fee cuts are unlikely to be enough to incentivise capital to remain in funds that have underperformed meaningfully this year.”

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While 2022 has been a challenging year for most hedge funds, firms such as Odey Asset Management and EDL Capital won big on rising volatility in the pound and global bonds.

The top-performing hedge funds are not only likely to keep their 2 and 20 arrangements but will raise fees further, Elliott said.

Some have already started introducing new fees. London-based Brevan Howard Asset Management is planning to pass certain expenses onto clients in its hedge fund via a new ‘pass-through’ fee, according to Bloomberg.

“The best funds that have strong track records of performance may be able to raise fees further and already have. The result will be an industry with lower assets under management, but better-returning funds than exist today,” the ETF Unlimited CEO said.

Despite tough market conditions, Elliott expects a year full of opportunities for hedge funds in 2023 driven by macro trends.

“Macro funds typically do well when large macro trends drive asset returns, particularly those that are unexpected. 2022 has already sparked significant interest in real assets and gold after a decade of underinvestment,” he added.

To contact the author of this story with feedback or news, email Bilal Jafar

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