How Do Hedge Funds Make So Much Money? Best Business Model In The World

888 Park Ave - Hedge Fund HQ

Are you wondering how do hedge funds make so much money? Working for a hedge fund is one of the most promising ways students from top universities try to get rich.

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.

Even Gabe Plotkin, the founder of Melvin Capital has made hundreds of millions of dollars despite being down 45% in 2021! That is awesome to get rewarded so handsomely, yet perform so poorly. Melvin Capital declined by another 50%+ in 1H2022 and finally shut down.

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 poor for a while now. Just take a look at the Hedge Fund ETF, HDG as one financial benchmark to gauge performance. Hedge funds have underperformed the S&P 500 every year from 2009 – 2020.

Hedge funds make money by charging a management fee and a percentage of profits. The typical fee structure is 2 and 20, meaning a 2% fee on assets under management and 20% of profits, sometimes above a high water mark.

For example, let's say a hedge fund manages $1 billion in assets. It will earn $20 million in fees. If the firm makes 20% and has no high water mark before the 20% kicks in, the hedge fund will earn $200 million X 20% = $40 million.

If the hedge fund has a 8% high water market, then the hedge fund can only earn 20% on $120 million, or $24 million in shared profits.

Best Hedge Funds Get All The Accolades

We only hear about the great hedge fund success stories and the spectacular failures like Long Term Capital Management and nothing in between. In the news today are hedge funds like Melvin Capital, getting blown up by Reddit retail investors who have bid up stocks like Gamestop and AMC Entertainment to astronomical levels.

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!

Let's look more into how hedge funds make money.

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.

How Hedge Funds Make Money

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 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.”

Hedge Funds Must Outperform To Make Big Money

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.

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.

Main Takeaways On How Hedge Funds Make Money

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.

Hedge Fund Fee Structure

The 2/20 fee structure (2% of assets under management, 20% of profits) 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, 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.

Related: Hedge Fund Pay By Title And Performance

Running A Hedge Fund Is Stressful

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!

Hedge Fund Performance Versus The S&P 500 In 2021

Below is a chart highlight how some of the top hedge funds performed in 2021 versus the S&P 500, which was up 28%. Only three of these hedge funds outperformed the S&P 500. But I can assure you that ALL the hedge fund managers made a lot of my for themselves.

The founder of Melvin Capital, -41.5%, bought himself a $50 million fat pad in Miami in 2021. It's great to be a hedge fund manager! But if a hedge fund can properly hedge, then it can save its investors money during a downturn.

Hedge Fund Performance 2021

Hedge Fund Alternative: Venture Capital

Instead of investing in a hedge fund, consider investing into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment. 

Check out the Innovation Fund, which invests in the following five sectors:

  • Artificial Intelligence & Machine Learning
  • Modern Data Infrastructure
  • Development Operations (DevOps)
  • Financial Technology (FinTech)
  • Real Estate & Property Technology (PropTech)

Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!

The investment minimum in the fund is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.

Manage Your Finances In One Place

The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Empower. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize.

Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month.

The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! 

There's no better free tool online to help you track your net worth, minimize investment expenses, and manage your wealth. Why gamble with your future?

Retirement Planner Personal Capital
Personal Capital's award-winning retirement planning calculator. Are you on track?

Real Estate Diversification

Finally, look to diversify your real estate investments across the country where valuations are lower, net rental yields are higher, and growth rates may be higher. The global pandemic has accelerated demographic shifts towards lower cost areas of the country due to the work from home trend.

Check out Fundrise and their eREITs. eREITs give investors a way to diversify their real estate exposure with lower volatility compared to stocks. Income is completely passive and there is much less concentration risk.

If you are bullish on the demographic shift towards lower-cost and less densely populated areas of the country, check out CrowdStreet. CrowdStreet focuses on individual commercial real estate opportunities in 18-hour cities.

Both platforms are free to sign up and explore. I've personally invested $954,000 in real estate crowdfunding across 18 properties to earn income 100% passively.

About the Author:

Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered.

In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $215,000 a year in passive income. He is most enthusiastic about investing in real estate crowdfunding for the future. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.

How Do Hedge Funds Make So Much Money is a Financial Samurai original post. Sign up for my free weekly newsletter where I've been helping people reach financial independence since 2009.

24 thoughts on “How Do Hedge Funds Make So Much Money? Best Business Model In The World”

  1. The way that hedge fund model is structured in US, UK, etc. never ceases to amaze me.
    Why charge 1 or 2 % performance fees when you can simply offer a fixed interest like 30 % a year to your investor and just keep whatever you make over that percentage to yourself, which amounts to well over 30% a year, considering the leverage certain non-US brokers provide and volatility in certain instruments like gold. I mean it’s not that big of an achievement to earn 50% on top of the initial amount and just give the investor 30% and keep 20% to yourself. Why be shallow asking for 1-2 % when you can just tell them – Today you give me 100k and you will get 130k exactly one year from today. Whatever I make over that 30% threshold off your money is mine to keep. Fair enough ?
    That is how I’ve been working for 13+ years now with my investors.
    Simplicity, straightforwardness and full transparency with no ifs or buts about it.

    Best,

    Omar.

  2. 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.

  3. 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.

  4. 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.

  5. 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. 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.

    1. 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.

  7. 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.

  8. 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.

    1. 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!

  9. 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.

    1. 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.

  10. “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.

    1. 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.

      1. 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.

        1. 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.

        2. 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.

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