How do hedge fund managers make money

How do hedge fund managers make money

By: InSEOnoIMO Date: 11.07.2017

This is the time of year when publications that cover the hedge-fund industry do their annual rankings, and people get irate about the vast sums of money that the top hedgies make—in some cases, billions of dollars. Questions can be raised about these and similar figures from other publications, which are rough guesstimates based on the size of the funds and the returns they made last year.

The hedge-fund industry is famously secretive. Nobody, not even the paid defenders of hedge funds, contests the fact that some of them generate gargantuan profits for their owners and managers.

Now and then, this stirs up moral outrage. But my point here is different, and it receives rather less attention: How the heck do these guys make so much money, year in and year out?

A big part of the answer is the hefty fees they charge. To put it a bit more technically: Why do investors in hedge funds—the people whose money is at risk—continue to allow the managers of the funds to dictate such onerous terms to them?

Years ago, defenders of hedge funds argued that they earned their money by delivering above-market returns on a consistent basis, but this argument is much harder to make these days.

For five years in a row, hedge-fund returns have trailed the stock market. Last year was a real doozy for the industry. According to Bloomberg, the typical hedge-fund return net after fees was 7.

Not to belabor the point, but investors in hedge funds paid through the nose for this underperformance. You can invest in an S. Of course, the hedgies at the top of the rankings did considerably better than the average fund. Those were the top performers. In many other cases, hedge-fund managers were paid hundreds of millions of dollars even as they failed to beat the market by a considerable margin. Does this really matter? Decades ago, investors in hedge funds were almost all very rich people.

These days, though, institutional investors, such as pension funds, charitable endowments, and even government investment funds, are big investors in hedge funds. To some extent, at least, the hedgies, with their exorbitant fees, are pocketing money that could be going to teachers, firefighters, and ordinary taxpayers.

So how do they get away with it? In carrying out their normal business, institutional investors are eager to get a break on the fees they pay to firms that manage their money.

That helps to explain the rise of index funds and exchange-traded funds, which are much cheaper than actively managed mutual funds. Index funds purchase all the stocks in a given index.

Hedge fund structure and fees (video) | Khan Academy

Actively managed funds try to beat the market by selecting various individual stocks. Last year, the California Public Employees Retirement System, known as Cal PERS , announced that it was switching more and more of its assets to index funds and other passive investments.

how do hedge fund managers make money

In the United Kingdom, the government has just announced that almost half of all the assets controlled by local authority pension funds will be switched to index funds in order to save cash. How has the hedge-fund industry escaped this cost-cutting trend? Institutional investors are forcing some hedge funds, particularly the newer ones, to back off the old two-and-twenty formula.

And yet, the biggest and most successful funds have been largely immune to this austerity drive. Some them charge even more than two and twenty SAC, before the government effectively closed it down for being a hotbed of insider dealing, was reputed to charge three and fifty.

And, of course, a fee structure of 1.

If, last year, I ran a hedge fund with five billion dollars under management, had charged those fees, and had merely matched the stock market, I would have made more than four hundred million dollars.

How on earth do they get away with it? Competition and entry should drive down prices. At the very least, you would think that there would be a movement to change the performance fees so they are assessed relative to the market return, rather than relative to zero.

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