Two and twenty (or "2 and 20") is a fee arrangement that is standard in the hedge fund industry and is also common in venture capital and private equity. Although it is the most traditional model used, managers are facing mounting pressure to reduce fees. After all, high fees destroy value and reduce the attractiveness of alternative investing.

Custom Fee Arrangements

Analysts need to be aware of any custom fee arrangements in place that will affect the calculation of fees and performance.

- Fee discounts based on custom liquidity terms or significant asset size. For example, in exchange for reduced fees, an investor may agree to a longer lock-up period. There are share classes with lower fees for larger investors.

- Special share classes. For example, "Founder Class" investors can pay a 25% to 50% lower performance fee than other classes in the fund until the fund reaches a certain asset size or an agreed upon period of time has elapsed.

- "Either/or" fees. Manager can either charge a fixed management fee or a higher performance fee but not both. The exact mechanics of the arrangement can be calibrated such that the economics of the fee structure remain similar, whilst the alignment with the investor is strengthened.

A fund of funds invests in a portfolio of hedge funds to provide access, diversification, risk management and due diligence benefits to investors. Such funds of funds generally charge a fee for their services. Recently funds of funds have been criticized for the significant incremental costs they impose.

Alignment of Interests and Survivorship Bias

When comparing the performance of alternative investments versus an index, the analyst must be aware that indexes for alternative investments may be subject to a variety of biases.

- Survivorship bias is the situation where unsuccessful funds are removed from the index, and the past index values are adjusted to remove the data of the dropped fund. Since a fund is more likely to be dropped from an index because of poor performance, such actions create bias in the index.

- Backfill biases means that when a new hedge fund is added to an index, the past performance of the fund is back-filled in the index. For example, if the hedge fund is 3 years old, it's record for the past three years will be added to the index, and the index values will be adjusted accordingly. The successful funds are more likely to be added to an index than an unsuccessful one, which creates a bias in the index.