Why Do Hedge Fund Managers Make So Much? - YouTube

INTRO: 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 over $2 trillion.  So, it’s understandable that Tim Cook is paid  

so much. But, with 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 realize  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 are 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, their  

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 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’s 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 their positions.  

If a fund has a beta value of 1, that means that  their positions 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 dotcom 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 95%. And given  

that 99% of his wealth was tied up with Amazon,  he was bagholding 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 are 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 on 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 breakeven. 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 you 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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