So You Want to Run a Hedge Fund?

Hedgies have a certain stereotypical image portrayed by the press. That image is typically a male, about 40-70 years old, making hundreds of millions or billions of dollars a year. This sells newspapers and lexuses. Media hype helps market the hedge funds via mystique and boundless success.

The truth, while nice, is not as grandiose. Depending on whose database you follow, there are 8-12,000 hedge funds globally. The term hedge fund itself is elastic enough to basically include anyone, who will place a bet on anything on someone else' behalf and charge 2 & 20 for the privilege.

Here is a little data. Hedge funds' success is like movie, sports etc. success in that a few do extremely well and most do fairly well. The average (median hedgie) doesn't own or probably even lease a plane. Note the data below most likely overstates incomes and returns due to survivorship and reporting bias which is significant in most hedge fund databases. They are marketing tools after all.

Here is a breakdown using the Tass database over time. One can see the evolution of a cottage industry paying white collar professional level salaries and then exploding. More recent data would be interesting to see. I have included the spreadsheet Download HedgeFund Data gogerty dot com I built for those interested in playing with assumptions behind the data. Also note that some funds have a hurdle rate which may downplay the income more.

If anyone is interested in chatting about what makes a fund a more "successful business" drop me a line. Getting more AUM (assets under management) is the goal of most funds. The maintenance fees of 2% are ridiculously high.

The magic threshold in the business is $100m AUM with +36 months of exposure because these are the operational levels, where most institutions start looking around at allocations. Please note instituional sales cycles for allocations are 9-12 months, while family offices are estimated at 12-18 months.

Under the $100m AUM level is noise and chasing high nets etc, which means lots of due diligence for small allocations.

The business of a hedge fund is investing, back office process and sales in that order. Growing and maintaining AUM is about establishing trust and faith in all the funds ongoing processes.

Returns in the form of track records and risk-adjusted track records are a small part of this equation. The back-office operations need to be stable and in place for real money to show up.

Return and Risk at the business level of hedge funds are as important as return and risk at the trading/allocation level of running the business.

Having top quartile risk-adjusted returns is a good start. Pros want to know about risk, ie. after verifying the apparent stability of the returns on the money, the need to verify the return of the money. Fashions also come and go in the various hedge fund sectors, but as a manager, it is best to stick to your knitting. Offering a 100/130 product for a long short value fund may work, but moving from value to convert arb is a stretch.

Mature back offices, SMA (seperately managed accounts), operational stability and experience, as well as lots of checks and balances are vital to this part of the allocaters' due diligence process.

At the end of the day, the more transparent all processes are in a fund, the more successful it should be. There are a few black box exceptions to this rule, but trust in process and people is vital to fund's survival. This is more than logos with greek columns and names that end in Capital.

Madoff was dodged by many banks who didn't understand the process he was claiming to be using. Acknowledging acting on one's ignorance is a powerful thing. If you don't understand it, move on. "not getting it" may not be cool, but it is wise. Know thyself.

Another benefit of having investors understand about an operational and investment process is that they are more likely to stick around during tough times. Many funds' revenue declined this year relative to previous years even though performance may have been extraordinary even adjusting for high water marks. Redemptions reflect a lack of faith potentially in many things, don't make them your people or your process.

Revenue declined for funds due to skittish investors who sold the "low" of the fund. Research into hedge funds and mutual funds shows the median investor underperforms the funds they invest in, due to buying high and selling low.

If someone doesn't have faith in the process, they are betting on your last month or quarter etc. This isn't any way to build or run a business. I advocate transparency and openness wherever possible for a fund or fund of funds, as it helps to retain clients. The risk of course is that it shows a lot of these funds or FoF's for the smoke and mirrors they are. Some black boxes in this business are black because they are full junk, see Galleon, Madoff etc.

One could argue Buffet runs a hedge fund with an open structure that makes him immune to capital calls; this allows him to retain cash at the most interesting times without having to change the rules of the game midstream such as putting up gates etc.

Running a small business, be it a hedge fund or dry cleaner, is about trust and process building with employees, customers and anyone else who comes into contact with your firm. Low trust or alpha male power based cultures should be avoided at all times. Bullshit and bravado are often bedfellows.

About the charts above: my cost assumptions are for a small fund with 3 full-time employees, a basic master feeder structure, no marketing payouts and outsourced legal, accounting and reporting functions in small office. The incomes are probably over stated 20-40%

Comments

[sethmcs:]

Do these figures include Madoff's fund?

Nov 08 06:11 PM

[Nick Gogerty:]

<img class="authors_reply" src="static.seekingalpha.co...">

I would assume they do, but don't have the detailed source data to verify that. I used summary data from a (iijournals.com) paper. Madoff and other giant funds are the reason I focus on median versus mean in terms of what a typical manager experiences running their fund business. Madoff's returns reported were around 11% and as a single non-AUM weighted variable shouldn't skew the median returns much. From a median AUM size perspective with thousands of funds Madoff shouldn't swing the median AUM figure too much either.

Nov 08 06:43 PM

[Peter Mycro...:]

Most RIA's charge a 1% fee of Assets under management (AUM). Before starting my own RIA, I considered opening a Hedge Fund, but I did not feel morally right about charging 2 and 20. Anyways, who can afford the insurance, the lowest quote I got was for $30,000 a year.

As an RIA I can help all kinds of investors, while Hedge Funds can only invest for fat cat's and Institutions. Since I am an analyst as well as a financial advisor, I feel that I am giving my clients a fair deal in just charging them 1% of AUM. I could not look a client in the face and charge them 2 and 20. I just don't know how the industry can get away with it.

I feel the Hedge Fund industry will soon get regulated, similar to what RIA's go through, especially with all the insider corruption that is in the news these days.

Thanks for the data, great article.

Nov 09 01:01 AM

[ValueInvestor:]

As a hedge fund employee I don't see how a 2% management fee is really all that big. If 100 million AUM is the target that would imply a revenue stream of $2.0 million for a year. In a level or down market, that's the company's revenue for the year and depending on the number of employees it doesn't leave much for insurance, rent, software (databases, market data quotes, MS word, excel), hardware and a myriad of other expenses. This is basically just to cover expenses, which can get quite high when a quoting system is $600+ per month, per machine or a database system is $10,000+. When you get into the billions of AUM then 2% seems high, but for small to mid-sized companies its not.

The performance/incentive fee is where the real money is. I would say 20% is high. 10% would be more appropriate IMO. Also, the SEC should pass a law stating all hedge fund managers should work as a fiduciary for all clients.

Nov 09 04:25 PM

[Old Trader:]

I would tend to agree with ValueInvestor, that in the case of a fund with an AUM in the $100M range, the 2% management fee doesn't result in the fund principals living "high on the hog", in the lfestyle depicted/chronicled in the media.

To Peter Mycroft, I'd suggest that "results" are what would justify the 2/20 structure. If an RIA can provide comparable returns, why shouldn't he/she charge similar fees?

Finally, if I were to invest in a hedge fund, I'd be interested in knowing if management has "skin in the game"...always a decent "tell", imho.

Nov 09 07:15 PM