How Do Hedge Funds Make So Much Money? An Inside Look At The Best Business Model In The World
Elephant hedge fund managers make $100 million a year CEOs look like mendicants. Guys like David Tepper from Appaloosa, George Soros from Soros, Ray Dalio from Bridgewaters Associates, and James Simons from Renaissance Technologies have all pulled in $1 billion+ paydays for one year’s worth of work before. Is there any wonder why some of the brightest minds want to rush into the hedge fund industry after getting their MBAs or PhDs in mathematics? Saving the world will just have to wait.
The reality of the hedge fund industry is that performance has been piss poor for a while now. Just take a look at the Hedge Fund ETF, HDG as one financial benchmark to gauge performance. The index is up a paltry 2% as of July 2013 while the S&P500 is up over 17%. To pay a 2% management fee and 20% of profits to underperform the broader index by 15% is a travesty. Investors need to demand better.
We only hear about the great hedge fund success stories and the spectacular failures like Long Term Capital Management and nothing in between. Much like in the startup business, most hedge funds fail because they are unable to outperform the markets over a three year period to raise enough capital to make a worthwhile profit. The industry is seeing fee compression given returns have been so poor. That said, all it takes is one or two years of hitting it out of the ballpark to make your mega-millions and retire.
I firmly believe the hedge fund industry has the best business model in finance, if not the world today. Those in the software industry might argue otherwise!
A VISIT TO 888 PARK AVENUE, NEW YORK, NEW YORK
I went to visit an old Goldman colleague who joined the hedge fund industry about eight years ago earlier this month. He has since ascended to TMT (Tech, Media, Telco) portfolio manager at a $5 billion dollar + total AUM hedge fund. I’m sure he’s pulling in multiple six figures if not seven figures a year, but I didn’t ask. I mainly wanted to catch up to see how he and his family were doing. We started our careers in the trenches at 1 New York Plaza and have stayed in touch ever since.
After downing a beer we talked about whether there was still tremendous upside in the hedge fund industry given industry performance and the zeroing in by the government. He said, “Things have changed. Stevie Cohen (of SAC Capital) is really making things more difficult for the rest of us now. He wisely implement a 3-year compensation rule where if your picks made big returns in the first couple years but gave it all back in the 3rd year you wouldn’t get paid. In addition, his government persecution is really unsettling.”
Federal authorities in New York City on Thursday, 7/25 charged SAC with wire fraud and four counts of securities fraud, but the multi-billionaire owner Steven Cohen is not charged. One of the main issues is oversight. With a firm as large as SAC and information sometimes as fluid as water, how does the bossman have total oversight?
My friend went on to explain, “It doesn’t pay to take huge bets anymore. It’s all about risk management and survival. Our goal is to extract alpha by going market neutral (same amount of longs and shorts) and leveraging up massively to exploit alpha. If we can return 5-8% in an up year and in a down year, that should be good enough to keep business flowing for a very long time.”
I make an argument that you are not a real investor if you do not produce alpha. You are certainly a prodigious saver if you methodically contribute to your stocks and funds every month. But a successful investor is someone who looks for ways to consistently outperform since everything is relative. BTW, have you taken a look at SINA, BIDU, and RENN lately? If you got long when we discussed in May, you are killing it right now with BIDU alone up 30%.
Example: Imagine running a $10 billion hedge fund. Taking a 2% management fee is huge. You automatically make $200 million a year without providing any returns. Even if you provide negative 10% returns, you’re still going to rake in $180 million in fees. If you can return 8%, or $800 million and take 20%, that’s another $160 million in income coming through the pipes. $360 million can easily pay a staff of 100 people handsomely along with a 20,000 square foot office. Like any good business, it’s all about scaling up to make the most amount of money. It takes an equal amount of brain power to run $100 million dollars as it does $10 billion dollars.
Asymmetric risk and reward is finally beginning to disappear. No longer can a hedge fund easily shut down an underperforming fund that will never get back to its high water mark and start a new fund to reset the hurdle. If you underperform over three years, you are done because there are thousands of other hedge funds to choose from. A high water mark is the level where a fund must breach in order to start collecting their 20% of profits again. If you are down 50% one year, you are basically screwed because it takes a 100% return just to get back to even. If a fund is big enough and investors don’t withdraw, the 2% management fee could keep things afloat for awhile.
The 2/20 fee structure is slowly coming down to 1/10 given the supply of hedge funds and lacksidasical performance over the past 10 years. The gig is up and investors realize it’s extremely difficult to consistently outperform the markets and provide positive alpha. Only a few firms like Renaissance, Soros, Appaloosa, SAC Capital, and Citadel have done the impossible, and they are able to gather the most assets and command the highest fees as a result. It’s always the case where the best take the lion’s share of business.
If you want to make money, get into an industry where a large percentage of revenue goes to the employees, and not to the shareholders. Take investment banks for example. It was common place for employee compensation to be 50% of total revenue. The more the employees and owners make, the less you get as a shareholder. This is why there is so much investor activism, especially when CEOs get paid millions for underperforming. You are either going to join them through employment or stock ownership or not. There’s no complaining in a free world full of opportunity.
The final takeaway is that being a hedge fund manager is no longer fun as it once was. It’s the reason why funds such as Soros have returned capital to shareholders and is just run by family. If you’ve got billions already, why bother opening yourself up to government scrutiny? It’s all about the spirit of competition at that level.
Regardless of the decline in profitability of the hedge fund industry, it’s still worth a shot at trying to make the big bucks if you’ve got the opportunity. I know so many fellas who crushed it for two or three years and then closed up shop due to wrong bets. The best firms hire from only a focused set of universities, so study hard and don’t screw things up if you’re still young. If you’re already old, then try to run your wealth as a multi-strategy hedge fund manager to control risk. Perhaps one day you too can yell out, “Fire up the jet, Alfred!”
Leverage + Risk Control + Sustainability + High Fees = Great Business Model!
Update 11/2013: SAC Capital Advisors pleads guilty to criminal fraud charges, agress to stop investing money for others and pay $1.8 billion in fines. Let’s see if multi-billionaire Steve A. Cohen goes to jail, or gets to keep his billions like he probably will.
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