How Do Hedge Funds Make So Much Money? An Inside Look At The Best Business Model In The World

888 Park Ave - Hedge Fund HQElephant 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.

Pathetic Hedge Fund Performance

S&P 500 (Green) trouncing hedge fund performance over two years.

MAIN TAKEAWAYS

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.

Regards,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    “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.” True, but if you want to be a consumer, look for a company where most of the value goes to the consumers. I would say that by and large the hedge fund industry has failed that second test. I would also say that you can look at the top performers and argue over whether they’re truly good or just lucky. Pure chance will let some rise to the top.

    Being a hedge fund manager seems like a great way to get rich. Investing with a hedge fund seems like a great way to lose money.

    • says

      Focusing on an industry where a large share of revenue goes to the owners/employees really is an important issue to understand for those who want to make more money through employment.

      Hedge funds do much better in a bear market by nature of its mandate. In a bull market like we’ve seen over the past 4 years, it’s practically an inevitably they will underperform.

      So for those high net worth individuals who are all about capital preservation, hedge funds remain an attractive option.

      • says

        I’ve never understood the argument that high net worth individuals need some special investment strategy. Maybe you can explain it to me. But if the concern is wealth preservation, what’s wrong with something like a 20/80 stock/bond split using index funds with the bonds primarily short-term treasury bonds? Wouldn’t that accomplish the same purpose without the crazy fees? Obviously you could debate the exact allocation, but the larger point remains.

        • says

          Because it would be nice to make money during downturns, not just lose less. That’s preservation and greed speaking. Besides, the wealthy are just farming out slices of their wealth for diversification. That’s what college endowments due as well.

        • says

          I think everyone would like to make money all the time, but that’s pretty much fantasy. From 9/2007-3/2009 (roughly peak to trough), a 20-80 allocation using VTSMX and VFISX lost about 1% annually. Since then it’s gained about 8% annually. It seems ridiculous to me to try for much better than that from a wealth preservation standpoint when you’re talking about such an enormous amount in fees with a sub-par track record as the alternative.

          College endowments and other institutional investors seem to be learning a similar lesson, as there seems to be a shift towards using more index funds. I doubt that they will be disappointed.

  2. says

    It seems like the party is a little too crowded right now so it’s very difficult for the all those hedgies to exploit inefficiencies in the market, like they once were able to do.

    I imagine when the dust settles, there will be a few survivors that can produce outsized returns, from time to time.

    But how do you know your guy/gal is going to be that one that year?

    Plus how do you know you guy/gal isn’t cheating to get there?

    I personally feel like the launch of HDG was the death knell. The jig was up when they started to sell the product to the masses.

    • says

      I think the HF industry has another 5 years of outsized returns ahead of them as they are now allowed to advertise/market their funds based on a new ruling. We’ll see. Making a million buck a year instead of $10 million a year is still not bad.

  3. says

    I am of the opinion that despite whatever is written on their mission statement, most fund managers (hedge, mutual, etc) aren’t really interested in making stellar returns. So long as they don’t massively under-perform, people and institutions will keep their money invested and the fund can keep skimming off egregiously high fees. A solid sales and marketing department can hand wave around the under performance with stories of super sophisticated proprietary trading systems that are poised to deliver groundbreaking returns, all presented in full color and delivered by some cute associate. And predictably people will keep their money invested there because finances scare most people.

  4. says

    I used to work as an accounting and tax analyst in the mutual fund industry, but hedge funds are a different beast and have always had a “mysterious” element to me. The insight you’ve provided here is very interesting. My takeaway, even if I had the brains to make my way into the industry, I don’t think I’d be able to handle the seemingly immense amount of stress.

    • says

      Yes, the stress is 24/7, especially for global funds, which basically every one is since we’re all tied. I think we can all handle 2-3 year of stress for big bucks. That’s all one needs though!

  5. says

    Eventually, I think the 2 and 20 fee schedule will be dead. Articles I’ve seen recently have said that the new normal is much lower. It should be. Also, seed capital for new funds is increasingly coming with an equity position in the fund company itself.

    The only fee schedule that makes sense to me is a high water mark and lower fees, or a hurdle requirement with 10-20% of returns for the management if they clear the hurdle. Buffett’s early partnership gave him 20% of all returns above 6%. Anything lower (even over a period of many years) meant he didn’t get a dime. That’s how it should be, as it aligns the portfolio managers with investors.

    Ultimately, I think it’s hard for managers to stay hungry when they pull in $200 million a year without any requirement for performance. You don’t need many $200 million years to be set for life. Also, the successful funds just become too big. It may not take more to manage a $20 billion fund than a $1 billion fund, but you have to find much bigger ideas in a much more efficient market running $20 billion rather than $1 billion. It’s much easier to find good ideas with smaller amounts of money.

    • says

      That’s very true about getting too big. Hard to put up the same type of returns giving liquidity constraints. Too big is a good problem to have!

      I wonder what Warren is gonna do with his $49 billion current cash hoard.

  6. says

    You don’t need that much money to be happy ! Besides a private jet is a waste of money. I would probably rent it out and generate income. The basis for good investing is keep your expenses down! Why would I want to add a 2% fee, if the return were not extraordinary? When the market is up, the index beats the managed investments and when it is down it is a rare managed investment beats the index by much. Now they have to beat the index by 2% just to be even.

  7. says

    Sam, you mention Leverage + Risk Control…, and I think that you really can’t have those two at the same time. They work in opposite directions. All the hedge funds that have failed have done so because of excess leverage and being unable to control the risks when reality departs from their models. So in short run scenarios, yes, it works great, you have incentive to juice risk hoping for that payday. But the lever in the long run (more than a few quarters) is leverage or risk control, you don’t get both as they are on opposing ends of the same dial.

    And as Matt mentioned above, as an investor, I’d never get into one of those. They are designed to put the risk on me as the investor with a large portion of the upside to the hedge fund.

    • says

      I think you can. For example, you can leverage your longs and shorts 10X to $10 billion exposure from $1 billion exposure if you’re trying to magnify and extra small percentages of alpha. But yes, being overly levered like the quant funds were in 2008-2009 was bad news. Everybody had the same trade.

  8. says

    I like what Warren Buffett did in the early days of Berkshire Hathaway. His transparent annual letters to shareholders kept the trust factor, and his returns spoke for themselves.

    You’re absolutely right, hedge funds are the worlds best business model. I see many clients at work with 7 and even 8 figure portfolios that are invested in HFs, and most of the time they view it as an “exclusive club” they belong to. Little do they know they’re getting robbed blind.

    Sam will disagree, but I’ll take admiral shares of the Vanguard 3 fund portfolio over any hedge fund, with or without fees.

    • says

      I won’t disagree about Vanguard funds over hedge funds. I think if you’ve got a lot of wealth, it’s worth allocating a portion of it to a fund manager with a long track record of outperformance. The amount is to be in question for everyone.

  9. says

    Great perspective Sam. The hedge fund industry has always been kind of a “black box” to me. I understand how traditional investment vehicles work, including stocks, bonds, and mutual funds. HOwever, how these firms do what they do was, and still is, a mystery to me. From an outsider perspective, I think it looks like a bit of an arms race right now. Technology is ultimately going to decide who gets the outsized fees. Whomever can develop the best software platforms to do their work will probably get the outsized portion of fees in the future. But, really, what does that say about the future of retail investing?

    I’m starting to see a future where the “common man” starts to gravitate towards crowd sourced funding options because the whole traditional model is starting to feel a bit tilted towards these “mysterious” funds.

    • says

      Renaissance Technologies by Ray Dalio has it made. The machines make the trades, and successfully they’ve done for years. So long as the machines work, all their employees get paiiiiid.

  10. GP says

    There is a debate over whether alpha (the manager’s skill element in performance) has been diluted by the expansion of the hedge fund industry. Two reasons are given. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry.

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