Hedge funds are a mysterious and fascinating industry. When the job title “hedge fund manager” is mentioned, the first related words that pop up in most people’s minds are probably: smart, rich, and very rich.
You may be wondering why hedge fund managers make so much more money than general fund managers. It mainly depends on three factors: the way hedge funds make money, the hedge funds assets under management (AUM), and how hedge fund managers charge fees of AUM.
Table of Contents
- The Difference Between Hedge Funds and General Funds
- How Hedge Fund Managers Make Money?
- The Hedge Funds Assets Under Management (AUM)
- How Hedge Funds Make Money?
- Final Thought
The Difference Between Hedge Funds and General Funds
The main difference between a hedge fund and a general fund is its risk. A hedge fund can win big as its high leverage, which enlarges the profits, while its losses can also be larger.
Generally speaking, you give money to one person, and he establishes a fund and takes a lot of people’s money and invests it in a place where he thinks the money can appreciate in value. After earning money, he will distribute some to you.
Hedge means to hedge the risk, however, the investment portfolio of a hedge fund is relatively risky. The government has strict supervision on general funds such as pension insurance and medical funds. However, hedge funds have fewer investment restrictions. Meanwhile, hedge funds can use high leverage, at the same time with high risk.
Therefore, hedge funds have high requirements for investors. For example, only rich people can invest.
How Hedge Fund Managers Make Money?
The wealth of hedge fund managers seem to be nothing new. Because in most people’s minds, hedge fund managers earn extraordinarily well because they have “skill.” They are able to generate excess investment returns for their investors, so their own high incomes seem to be natural and no fuss.
Few people think about it: There are so many very wealthy hedge fund managers in the world, but why do we rarely hear about investors who made their fortunes investing in hedge funds? If we search the Internet for the highest-paid hedge fund managers, we can easily get a long list of familiar names. But if we searched for the list of the highest-paid hedge fund investors in the world, it would be hard to find good results.
Hedge Funds Fee 2/20 Structure
In fact, one of the most important issues that most people ignore is the fee structure for hedge fund managers. The first thing we need to do to understand the secrets behind hedge fund managers’ staggeringly high incomes is the ins and outs of fund managers’ fees.
In the hedge fund industry, there is an operating rule called 2/20, that is, fund managers charge a 2% base management fee of the assets each year no matter performing well or not, and at the same time charge a 20% performance share at the end of the year.
For example, Chris Hohn’s TCI Fund Management made $9.5 billion (23.3% profits) for clients last year, which mean he could earn approximately $40 billion(managed assets) *(2% + 21.3% *20%) = $2.5 billion.
Investors Misunderstanding of Hedge Funds Fee Structure
Investors will feel that even if I give the manager a 2% management fee, I still have 98%. Even if I give the fund manager 20% of the performance, I can get 80% myself.
But in fact, this is the illusion of many investors. This is because investors put their money in the hands of hedge fund managers, mainly because the fund managers can provide “alpha” (excess returns). If a fund manager simply gives investors a “risk free rate” or “beta (market return)”, the fund manager is ineligible, and he shouldn’t charge investors anything for those returns.
Hedge Funds Fees Examples
Under a fee model where hedge fund managers charge both high management fees and performance shares. Suppose a fund manager offers a 20% annual return before fees. Of this 20% return, 3% is risk free rate, 12% is market return (beta), and 5% is excess return (alpha).
If we assume that the fund manager charges a 2% management fee and a 20% performance share, then the final fee charged to the investor (5.6% = 2%+18%*20%) accounts for 112% of the excess return (5% alpha).
If the fund’s annual return is 25%, then 66% ((2%+23%*20%)/10%) of the excess returns created by the hedge fund manager will be owned by himself. And if the fund’s return rises to 30%, then 50.6% ((2%+28%*20%)/15%) of the excess return the fund manager creates goes into his pocket.
That is to say, the vast majority of the investment value created by a hedge fund manager is not enjoyed by investors, but goes into his own pocket. That’s why the hedge fund manager is becoming rich and rich.
The Hedge Funds Assets Under Management (AUM)
Assets Under Management (AUM) is a measurement of the financial size of a hedge fund. The AUM figure represents the total value of all capital managed by a hedge fund firm. It includes any money from investors which is currently being managed and reflects the net asset value of investments.
Hedge funds usually charge fees related to the AUM. The fee structure varies according to the strategy employed by the fund manager, but is typically 2% of total assets managed plus 20% of any profits earned. So if a hedge fund has $1 billion in AUM and a 2% management fee, the manager earns $20 million management fee, plus 20% of profits gained.
How Hedge Funds Make Money?
Generally, there are five ways or strategies that hedge funds make money. There are long/short equity, quantitative fund, global macro, arbitrage, and event-driven strategies.
1. Long/Short Equity
Long means buy, while short stands for sell. This strategy is the origin of hedge funds.
For example, you think the stock prices of electric car companies are high. You need to hedge the risk. Therefore you are long in one electric car company, while short in another electric car company.
The actual operation is much more complicated. You need to consider more items, such as correlations between stocks, indices, various leverages, and more.
2. Quantitative Fund
Quantitative funds are usually using machine learning algorithms to pick stocks and avoid mistakes. There are a lot of PhDs who are very good at modeling and programming looking for alpha. Alpha is the return above the market standard value. Top 10 fund size AUM such as D.E.Shaw, renaissance, Citadel, AQR, Two Sigma, etc.
3. Global Macro
Investing in macroeconomics means investing in products related to the national economy, such as investing in currencies, government bonds, and stock indexes. The more traditional one is to make profits along the economic cycle.
The BridgeWater become famous since 2008 financial crisis as its return is positive, while almost all of the other funds are negative.
There is another gang of investing macros, who is looking at the recession, and then set foot on it. The leader is Soros.
His famous battle was in the early 1990s when the British economy was bad and the currency depreciated, the Pound was linked to several other currencies.
The Bank of England kept buying its currency in order to prevent the pound from depreciating. Soros brought together a lot of predators, and then sold, shorting the pound. This sparked a massive sell-off of the pound. Soros made a profit of 10 billion.
Arbitrage is a strategy of high-frequency trading, by looking for small price differences, and quickly earning profits.
The most famous is the LTCM (Long Term Capital Management) hedge fund in 1994. They are an all-star team, with a lot of powerful people, attracting a lot of funds, the created 40% myth yield.
With its popularity, the leverage is getting bigger and bigger, and products are getting more complex. In 1998, due to the influence of the Ruble, LTCM crossed. Even the Fed cut interest rates and asked many investment banks to save him. Mr. Warren Buffett and Charlie Munger were the leaders to save LTCM.
Hedge funds provide competition and liquidity to the market by looking for arbitrage space and finding places where the value is unreasonable. The market also needs the existence of this arbitrage.
5. Event-Driven Strategies
Event-driven strategies such as acquisitions and bankruptcy. They guess an event will be successful or not, then make the decision to buy or sell. For example, Tesla was rumored to be added to the S&P S&P index some time ago. This is event-related.
Hope you now understand why hedge fund managers are so rich:
- The way hedge funds make money – the high leverage can make hedge funds win or lose big. The more profits the funds make, the more the manager will earn.
- The hedge funds assets under management (AUM)- which means the amount of money the fund has collected from investors. The more money the funds have, the more the manager will earn.
- How hedge fund managers charge fees of AUM – 2/20 rules. This fee structure means hedge funds can win big when winning; while losing, the clients lose but the hedge funds still win.
Hedge funds can give very high returns due to their high leverage. However, due to its low transparency, complex investment strategies, and little information disclosure, hedge funds are only suitable for a small number of professional institutions or rich people to invest in.
If you want to be a hedge fund manager, you need to have the ability to think independently, your own judgment and opinions.