What are hedge funds and why do hedge fund managers get paid so much?

Let’s take a look at hedge funds. They are no ordinary ways of managing money, they are amongst the most lucrative for the managers and highest returning. The list of people who made the most money from the stock market are mostly fund managers. But just what are hedge funds and how do they work?

What are hedge funds? And how do they work?

Hedge funds are investment funds. The term was invented by Australian-born investor A.W. Jones who is regarded as the founder of the first hedge fund, with a fund named after himself and is still operating today after his passing. He used short selling and leverage, both risky strategies in their own right, but actually less risky when used together and able to amplify returns. That fund was called ‘hedged’ to the extent the portfolio was split between stocks that would gain if the market went up, and short positions that would benefit if the market went down. Hence the term hedge fund, as well as the general term ‘hedge your bets’ which can be applied to many situations beyond sports betting.

Hedge funds are typically managed by experienced investment professionals who have the flexibility to invest in a wide range of assets, including stocks but also bonds, commodities, currencies, and real estate. They are often compensated with both a management fee and a performance fee – we’ll get to this later.

Why do hedge funds pay so much?

There are several reasons beyond the strategy of ‘hedging’ that we’ve already addressed.

First and foremost, hedge funds often require significant initial investments, making them accessible primarily to institutional investors and high-net-worth individuals. Investments in hedge funds tend to be less liquid than other investments, meaning that investors might not be able to withdraw their money quickly or easily – in fact, it is often deliberate in certain funds.

Also, hedge funds are typically subject to less regulatory oversight compared to mutual funds. This allows them more flexibility but also poses higher risks.

Another key reason is because hedge fund managers are often paid very high salaries and bonuses, and this is primarily due to the structure of their compensation and the potential for high returns on investments.

How hedge fund managers are compensated

• Performance Fees (Incentive Fees): Hedge fund managers typically earn a performance fee, which is a percentage of the profits the fund generates. A common structure is the “2 and 20” model, where the manager charges a 2% management fee on assets under management (AUM) and a 20% performance fee on any profits made. This aligns the manager’s interests with those of the investors, as the manager benefits directly from the fund’s success.
• Management Fees: In addition to performance fees, hedge fund managers charge a management fee, which is a fixed percentage of the total assets under management. This fee compensates the manager for their time, expertise, and the operational costs of running the fund. Even if the fund does not perform well, the management fee provides a steady income. For instance, a 2% management fee on $1 billion AUM (Assets Under Management) amounts to $20 million annually, before considering performance fees.

One should remember that hedge fund managers are often highly skilled and experienced investors who employ sophisticated strategies and have deep knowledge of financial markets. Their ability to generate high returns in various market conditions is highly valued.

Moreover, even in spite of the ‘hedging’, they often take significant risks to achieve high returns. In the eyes of the HR professionals at hedge funds, potential for substantial profits justifies high compensation, especially if they can consistently deliver strong performance. We’ll leave others to form their own opinions on whether or not the justification is there.

We would observe that structure of hedge fund compensation is designed to align the interests of the managers with those of the investors. If the fund performs well, both the investors and the managers benefit. This motivates managers to strive for exceptional performance.

Conclusion on hedge funds

Hedge funds are like the Qantas Chairmans’ Lounge. If you need to ask, you probably don’t belong there in the first place – as sad as it is. They are used by Ultra High Net Worth individuals to achieve a return above and beyond the market, and are so called because fundies ‘hedge their bets’ to achieve a return.

So next time you wonder why hedge fund managers are paid so much, there may be a little less doubt about why.

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