How Do Hedge Funds Make So Much Money? Best Business Model In The World (2024)

How Do Hedge Funds Make So Much Money? Best Business Model In The World (1)

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.

How Do Hedge Funds Make So Much Money? Best Business Model In The World (2)

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 theInnovation Fund, which invests in the following five sectors:

  • Artificial Intelligence & MachineLearning
  • Modern DataInfrastructure
  • Development Operations(DevOps)
  • Financial Technology(FinTech)
  • Real Estate & Property Technology(PropTech)

Roughly 35% of the Innovation Fund is invested inartificial 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 withEmpower. They are afree 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?

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 outFundriseand 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 outCrowdStreet. 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.

How Do Hedge Funds Make So Much Money? Best Business Model In The World (2024)

FAQs

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

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.

How the world's largest hedge fund really makes its money? ›

According to a person briefed on the investigation, what they concluded, in part, was that the world's biggest hedge fund used a complicated sequence of financial machinations — including relatively hard-to-track trading instruments — to make otherwise straightforward-seeming investments.

How are hedge funds so profitable? ›

Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.

How do hedge fund managers get so rich? ›

Hedge fund managers typically earn above-average compensation, often from a two-and-twenty fee structure. Hedge fund managers typically specialize in a particular investment strategy that they then use to power their fund portfolio's mandate for profits.

Why do hedge fund guys make so much money? ›

Why Do Hedge Fund Managers Earn So Much? Hedge fund managers' earnings are usually based on management fees and a percentage of the profits they earn, known as a performance fee. The more assets they have under management, and the higher the profits they earn for their fund, the more income they make.

Why do rich people invest in hedge funds? ›

Hedge funds originated as a vehicle to help diversify investment portfolios, manage risk and produce reliable returns over time. While hedge funds' investor base has evolved though the years – from individuals to institutions such as pensions, universities and foundations – their core goals have remained the same.

What is the most profitable hedge fund ever? ›

Citadel, a Miami-based multistrategy hedge-fund firm, led the list with a $74 billion net gain for its investors since inception in 1990 through 2023. It racked up an $8.1 billion profit last year.

Why are hedge funds so secretive? ›

Employees are often required to sign stringent non-compete agreements, ostensibly to protect trade secrets. And even basic information like fund returns is not commonly reported publicly. The conventional wisdom is that this lack of transparency is a trade-off for better performance.

Is BlackRock a hedge fund? ›

BlackRock manages US$38bn across a broad range of hedge fund strategies. With over 20 years of proven experience, the depth and breadth of our platform has evolved into a comprehensive toolkit of 30+ strategies.

Do hedge funds actually beat the market? ›

Key Data Points. Data from an article by The American Enterprise Institute charted the average hedge fund's performance from 2011 to 2020. Over that stretch, the typical hedge fund underperformed the S&P 500 every single year. Again, there will be an occasional manager who outperforms, but rarely does it last long.

Do billionaires use hedge funds? ›

The recent Forbes 400 (richest American billionaires) list has about 112 people, by my count, who made their fortunes in some form of Finance, Investments, Hedge Funds, insurance or banking.

Is Warren Buffett a hedge fund manager? ›

In fact, he owned and managed his own hedge fund before he took charge of Berkshire Hathaway. He introduced Buffett Partnership, an early version of hedge funds, in 1957, and it was wildly successful. In the 12 years he managed the fund, Buffett delivered compounded annual returns of 31.6 percent before fees.

Do hedge fund managers make millions? ›

The top individual Portfolio Managers can earn hundreds of millions or billions each year. Hedge funds offer a much higher pay ceiling than investment banking, (sometimes) better hours and work/life balance, and the chance to do more interesting work.

Who is the richest hedge fund manager? ›

Here are the 20 richest hedge fund managers on Forbes' 2023 World's Billionaires list:
  1. #1. Ken Griffin. Net worth: $35 billion. ...
  2. #2. Jim Simons. Net worth: $28.1 billion. ...
  3. #3. Ray Dalio. Net worth: $19.1 billion. ...
  4. #4. David Tepper. Net worth: $18.5 billion. ...
  5. #5. Steve Cohen. ...
  6. #6. Carl Icahn. ...
  7. #7. Michael Platt. ...
  8. #8. Israel Englander.
Apr 4, 2023

How much does a CEO of a hedge fund make? ›

The median manager earned $570 million — the fourth best in 22 years — and the seven highest earners all made at least $1 billion. The top earner was Ken Griffin, founder of multistrategy giant Citadel. He personally made $4.1 billion — the most any hedge fund manager has ever earned in the history of the Rich List.

What is the highest paying job in a hedge fund? ›

What are Top 5 Best Paying Related Hedge Fund Jobs in the U.S.
Job TitleAnnual SalaryMonthly Pay
Hedge Fund Attorney$175,207$14,600
Cfo Hedge Fund$157,532$13,127
Private Equity Fund Controller$154,999$12,916
Hedge Fund General Counsel$151,643$12,636
1 more row

How did Ray Dalio make his money? ›

Ray Dalio made his money primarily by founding the world's largest hedge fund, Bridgewater Associates that manages over $124 billion. He began as a precocious investor who started buying stock when he was just 12 years old. His first investment, Northeast Airlines, tripled from $300 to $900.

Who owns the biggest hedge fund in the world? ›

Bridgewater Associates

Westport, Conn. Westport, Conn. In 1975, Bridgewater Associates was founded by Ray Dalio in his Manhattan apartment. Today Bridgewater is the largest hedge fund in the world and Dalio has a personal fortune of approximately $19 billion.

How do hedge funds make money from failing companies? ›

Hedge funds are able to purchase distressed debt (usually in the form of bonds) at a very low percentage of par value. If the once-distressed company emerges from bankruptcy as a viable firm, the hedge fund can sell the company's bonds for a considerably higher price.

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