Why Do Hedge Fund Managers Make So Much?

Why Do Hedge Fund Managers Make So Much?

When people think of the highest paying jobs in the world, they generally think of top executives.  And this makes sense given that people like Sundar Pichai and Tim Cook often pull in over a hundred million dollars per year. But, there’s actually one job that pays even higher and that’s being a  hedge fund manager. The top hedge fund managers aren’t just billionaires, but they literally make billions every single year.

In 2021, the top-paid hedge fund manager was ironically Ken  Griffin from Citadel who pulled in a total of $2.5 billion. Considering this insane income, you would think that these guys are the next Warren Buffett, but this isn’t exactly true. At least with top executives, they generally create a lot more value for shareholders than they’re paid themselves. 

For example, since Tim Cook became CEO, Apple’s market cap has grown by over $2 trillion.  So, it’s understandable that Tim Cook is paid so much. But, hedge fund managers, their performance is generally not only mediocre, but they often don’t even beat the market. Ken  Griffin's Citadel, for example, grew a solid 26% in 2021. This sounds really good until you realise that the S&P 500 itself grew 26.89% in 2021. So, Ken basically only had average performance, yet he received the highest salary in the entire world. So, why are hedge fund managers paid so much when their performance is at best mediocre.

CLIENT BASE:

To understand why hedge fund managers are paid so much, we have to first understand what type of person even invests in a hedge fund in the first place. In terms of qualifications, generally, you have to be an accredited investor and you have to be willing to invest a minimum amount of capital to be part of a given hedge fund. The top hedge funds generally have even stricter requirements given their notoriety. Citadel, for example,  requires that you have $10 million in investable assets to join their funds. Considering this, the average investor in hedge funds is billionaires and institutional investors like banks, pension funds, and retirement funds. And often, the top priority for these guys is not capital growth but rather risk minimization. Here’s the thing, if you’re a billionaire, your company and/or investments have been demolishing the market for several years if not decades. Take Jeff Bezos,  for example. Since Amazon went public, its stock has grown from $2 a share to about $3000  a share today after accounting for stock splits.

If we annualize this return, we get an average annual return of over 35%. Now, that might now sound like a lot given that the S&P 500 already averages 7-8% per year. But, when you compound this growth, things get wacky extremely quickly. For example, if you average 8% per year for 25 years, you end up with a solid 7.34x return. But, if you average 35% per year for 25 years, you end up with a 5500x  return. Considering this, someone like Jeff Bezos isn’t trying to maximize returns when they invest in a hedge fund. They’re trying to minimize risk.

This becomes even more important when you consider that most billionaires have their entire net worth tied up with 1 or maybe 2 companies.  But wait a minute, how exactly does a hedge fund even minimize risk in the first place? Well, one of their risk mitigation strategies is in their name, hedging. If you’re not familiar with what hedging is, it’s basically buying insurance on all of your positions by also betting the opposite of what you think is going to happen. For example, let’s say I’m a massive fan of Tesla and I think it’s going to 10x from where it’s at right now.

So, I go ahead and invest $10 into Tesla. If I  wanted to hedge this position, I would spend an additional $1 on betting that Tesla will go down.  There are multiple ways to do this from shorting to buying options to performing equity swaps, but the specifics don’t really matter. All you need to know is that this $1 position goes up in value if  Tesla stock goes down. Now, if my initial thesis was right and Tesla does 10X, I’ll lose the $1  that I bet against Tesla, but my initial $10 investment would grow to $100 meaning that  I still profited $89.

On the other hand, if my thesis is wrong and Tesla halves in value,  my initial investment would go down to $5. But, the $1 that I bet against Tesla might’ve grown to $3 or $4 meaning that I’m left with a total of $8 or $9. In this case, I only lost 20-30%  of my initial investment while the average Tesla investor lost the full 50%. And this is really the core of what hedge fund managers are paid to do.

BETA: 

Every hedge fund has a beta value depending on how much the given fund hedges its positions. If a fund has a beta value of 1, that means that its position will perform exactly in line with the general market. If the S&P 500 goes up 5%, the hedge fund will also make 5% and vice versa. If a fund has a beta value over 1, this means that the fund is more volatile than the general market. If the market grows 5%, such a fund may grow 10%, but the thing to note is that, if the market drops 5%, such a fund will lose 10%. While there are some funds out there with a beta over 1, this is by no means the average hedge fund. A fund could also have a negative beta which means that the fund is inversely correlated to the market.  But, given that markets trend up with time, it usually makes no sense to invest in such a fund for an extended period of time. The average hedge fund usually has a beta between 0 and 1. This means that the fund is correlated to the market, but it will usually underperform the market both to the upside and the downside.

And with that being said, take a look at this graph comparing  S&P 500 and hedge fund performance. Clearly, hedge funds basically never beat the S&P 500, but focus on what happens when the S&P 500 is posting losses. Between 2000 and 2002, the S&P 500 lost  43% due to the dot-com crash. Meanwhile, hedge funds didn’t even have a single negative year.  Similarly, in 2008, the S&P 500 lost 37% while hedge funds only lost 22%. Now, for most people,  it would’ve just been better to hold the S&P 500 through such crashes given its superior overall returns. But, this doesn't apply to everyone. For example, let’s go back to Jeff Bezos. During the dotcom crash, Amazon stock crashed by 95%. And given that 99% of his wealth was tied up with Amazon,  he was bag holding quite a bit of Amazon stock.

Considering this, would it really have made sense for Jeff to invest the cash that he did have into the S&P 500 and bag hold that as well? Not really.  It would’ve made a lot more sense for him to have invested that money in a hedge fund and settled for lower gains and more safety. So clearly, hedge funds don’t have to beat the market for them to be appealing in certain situations.

With that being said, it really makes no sense to even compare hedge fund returns with the S&P 500. That’s like comparing bonds with the S&P  500 and then concluding that bonds suck given that they have lower yields. It’s not that one is superior and the other is inferior, they’re simply different instruments that make sense in different situations.

ALPHA: 

If it doesn’t make sense to compare hedge fund performance with the S&P 500 though, how should hedge funds be evaluated? Well, the answer is alpha. Every investment has a risk profile which like hedge funds is described by beta. And alpha describes how good your investment did in relation to its beta value. In other words, alpha is simply a way to measure risk-adjusted returns. For example, let’s say that in a given year,  the S&P 500 returned 12%. Meanwhile, you’re a fund manager who decides to invest in Apple. You think that Apple will outperform the S&P 500, but Apple is a bit riskier with a beta value of  1.2. Now, let’s say that Apple ends up producing a return of 15% which is 3% higher than the S&P 500.  By using this equation, we can determine that the alpha of this investment was positive 1.2% meaning that it was a good investment.

In this example, Apple stock outperformed the S&P  500 and our alpha was positive. But, an investment doesn’t need to outperform the  S&P 500 for our alpha to be positive. For example, instead of investing in Apple stock, let’s say we buy an Apple bond that yields 5% per year. While this investment has a much lower return than the S&P 500, it’s also much safer. And if its beta value is low enough, the Apple bond could still produce a positive alpha. Something to keep in mind though is that this same logic also works the other way around. Just because you beat the market doesn't mean that you’ll have a positive alpha. 

For example, if you produce a 100% return but your beta is 10, your alpha won’t be looking that great. Alpha is the primary benchmark institutions and billionaires look at when they invest in a hedge fund. And boasting a high alpha is usually the number 1 goal of any hedge fund. Ray Dalio, for example, has an entire group of funds that are called Pure Alpha. So, next time you see a headline that’s trashing hedge fund returns, don’t be fooled into thinking that these funds are garbage. The only way to really tell if they’re garbage or not is to look at their alpha.

COMPENSATION: 

Now that we’ve discussed the true goals of hedge fund managers and how exactly they achieve these goals, let’s talk about their compensation. The standard fee structure amongst hedge funds is the 2 and 20 rule. This means that fund managers are paid 2% of the entire fund's assets under management every single year regardless of how the fund performs. On top of this, they receive 20% of any profit they generate. This means that such funds have to grow over 2% every single year just for the clients to break even. Fortunately,  virtually all hedge funds average a return of at least 2% per year, but this does heavily dampen the net returns that the clients make.  

Not to mention, many of the positions that hedge funds take are short term positions meaning that clients have to pay short term capital gains taxes on these returns. Some funds do offer lower fee structures, but basically all of the flagship funds you hear about on the news use this structure. And given that such funds generally manage over a hundred billion dollars, it’s not surprising that their fund managers walk away with billions every year. In terms of the client’s perspective,  while it is true that these fees are quite high, you can’t really find hedging services for cheaper. You may be able to find better returns for cheaper, but you won't be able to find hedging services for cheaper given that hedging is quite work-intensive. Analysts on wall street generally work 100 to 120 hours every single week

While this is quite brutal, especially in the early days when you’re not making that much money, if you stick with it for 5-10 years, it’s quite reasonable to earn 7 figures every year. So, if you’re looking to make 7 figures when you’re young and don’t want to start a business, pursuing wall street is likely the most straightforward way to achieve it. With that being said though, there is a dark side to hedge funds. In order to achieve high alpha and minimize beta, hedge funds often use every trick you can think of. Everything from market manipulation and insider trading to pump and dumps and securities fraud. Most of the time, the SEC won't do anything about it, but even if they do, for many hedge funds, it’s just the cost of doing business.

The perks of insider trading and market manipulation are simply way higher than the minuscule fines from the SEC. And, in the end, it just comes down to one question: do the ends justify the means. Wall Street tends to think that it does while retail traders think that it doesn’t. Which side are you guys on? Comment that down below. Also, drop a like if you think Wall Street needs to be held more accountable.

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