By Elliot Eizik - December 2023
Rethinking Investment Fees: A Quantitative Look at Value vs. Volume
In the complex terrain of investment management, traditional fee structures often heavily favor the managers, not the investors. A prime example is the conventional '2/20' fee model – a 2% annual management fee plus 20% of the profits. However, a closer examination of the numbers reveals a compelling argument for a more equitable and conviction-driven fee approach.
The Costly Implications of the 2/20 Model
Let’s dissect this with real numbers. Imagine an initial investment of $100,000, growing at an annual rate of 11% over ten years. Under the traditional 2/20 model, the investor’s journey is as follows:
The final investment value, before fees, reaches approximately $283,942.10.
The total management fees over ten years amount to about $33,376.20.
A 20% fee on the final investment value also equates to around $46,400.27.
After these deductions, the investor is left with $152,224.90, a net gain of just $52,224.90 from their initial investment.
In stark contrast, the investment managers walk away with approximately $79,776.47, overshadowing the investor’s gain. A fee structure best described as “heads I win, tails you lose.”
A Fairer Alternative: Profit-Based Fees with a Hurdle Rate
Now, consider a more balanced scenario: a 25% fee on the profit, but only after a 6% hurdle rate is achieved. Using the same investment parameters, the outcome is significantly different:
The investment grows identically to $283,942.10.
In this case, the profit is $183,942.10 ($283,942.10 minus the initial $100,000).
Applying a 25% fee to this profit results in a management fee of about $45,985.52.
The investor, therefore, ends up with approximately $237,956.57, a substantial increase in net gain compared to the 2/20 model.
Why a Hurdle Rate and Profit Share Matter
This alternative fee structure yields a more significant return for the investor and aligns the investment group’s incentives with the investor’s success. It reflects a confident assertion that the investment strategies employed are effective and valuable.
A Call for a Paradigm Shift
The investment world is ripe for a change in fee structures. The traditional 2/20 model, while prevalent, doesn’t have the investor's best interest. It's time for investment groups to demonstrate their conviction in their strategies by adopting fee models that are fair, transparent, and aligned with the investor's success.
Conclusion
Finding an investment manager who embraces a fee structure based on profit sharing with a hurdle rate is challenging, yet it speaks volumes about their confidence and conviction. Unlike the majority who prioritize Assets Under Management (AUM) – akin to utility providers getting paid regardless of performance – managers who accept these terms demonstrate a commitment to aligning their success with their clients. This approach is not about playing it safe but rising above the herd with smart, value-driven strategies. While not foolproof, choosing a manager with such a bold fee structure is an excellent start to a potentially more profitable and equitable investment journey.
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