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.
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.
If You Want To Invest In A Hedge Fund
Going forward, hedge fund performance may improve given valuations are high and long-only returns may be lower. If you want to invest in a low-cost hedge fund, check out Titan. The investing platform only charges 1% and takes no percentage of profits.
I think investing with some downside protection makes sense after such a massive bull market since 2009. Here is more information in my Titan review.
Manage Your Finances In One Place
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Real Estate Diversification
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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.
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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.