What are hedge funds, why do hedge fund managers get paid so much and here are 5 of the most famous!

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?

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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.

Who are some of the world’s most famous hedge funds?

Let’s recap 5 of the most famous.

1. Renaissance Technologies (Medallion Fund).

Medallion was was founded by mathematician Jim Simons in 1982, is still operating today and is widely considered the most successful hedge fund in history.

Using highly sophisticated quantitative and algorithmic models, Medallion achieved extraordinarily high returns — historically estimated at over 60% per year before fees and around 40% net after fees over decades of trading — and generated more than $100 billion in trading profits since inception.

Medallion is closed to outside investors and reserved for current and former Renaissance employees, making its results legendary but inaccessible to most institutional allocators.

2. Citadel

Founded by Ken Griffin in 1990, Citadel is one of the world’s largest and most profitable multi-strategy hedge funds. Citadel’s flagship Wellington Fund and other strategies trade equities, fixed income, commodities, credit and more.

Over its history, Citadel has posted strong double-digit annualised returns, weathered crises (including positive performance in down markets), and made huge profits for investors. industry surveys estimate Citadel’s cumulative net gains since inception at tens of billions of dollars, with long-term annualised performance well above many hedge fund peers.

Its success comes from a diversified team of specialists, rigorous risk management, and heavy investment in technology and data.

3. Bridgewater Associates

Bridgewater Associates was founded by Ray Dalio in 1975 and pioneered the “global macro” style at institutional scale. Bridgewater’s flagship Pure Alpha fund blends macroeconomic insights with diversified bets across currencies, rates, commodities and equities.

Over its decades in business, Bridgewater has delivered attractive long-term returns through complex diversification and risk parity concepts, regularly generating positive performance even in volatile markets. In recent years it posted some of the best results in its history, underscoring its scale and resilience in diverse conditions.

4. D.E. Shaw & Co

Informally known as ‘Desco’ – this one was founded by David E. Shaw in 1988 and is one of the early pioneers of quantitative investing. Shaw combined systematic, mathematical models with deep research to uncover market inefficiencies across asset classes.

Its flagship Composite and macro-oriented funds have produced strong double-digit annual net returns in recent years, showing the durability of its systematic approach and diversified strategies. Its alumni includes Amazon founder Jeff Bezos.

5. Elliot Management

Elliott Management, founded by Paul Singer in 1977, is one of the most prominent activist hedge funds. Elliott targets undervalued, mismanaged companies and pushes for operational and strategic changes to unlock shareholder value.

With decades of campaigns in major corporations (from tech and telecom to distressed situations), Elliott is known for gritty activism. Its long-term annualised returns are estimated in the mid-teens, reflecting deep research and persistent engagement.

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.