What is hedge fund?

What is the difference between hedge funds and mutual funds?

Like mutual funds, the basic idea behind hedge funds is investment pooling. Investors buy shares in these funds, which then invest the pooled assets on their behalf. The net asset value of each share represents the value of the investor’s stake in the portfolio. In this regard, hedge funds operate much like mutual funds. However, there are important differences between the two.

1.    Transparency:
Mutual funds are subject to the Securities Act of 1933 and the Investment Company Act of 1940 (designed to protect unsophisticated investors), which require transparency and predictability of strategy. They periodically must provide the public with information on portfolio composition. In contrast, hedge funds usually are set up as limited liability partnerships, and provide minimal information about portfolio composition and strategy to their investors only.

2.    Investors:
Hedge funds traditionally have no more than 100 “sophisticated” investors, in practice usually defined by minimum net worth and income requirements. They do not advertise to the general public, although the recent trend is to market as well to ever smaller and less sophisticated investors. Minimum investments for some new funds are as low as $25000 compared to traditional $250000-$1 million minimums.

3.    Investment strategies:

Mutual funds lay out their general investment approach (e.g., large, value stock orientation versus small-cap growth orientation) in their prospectus. They face pressure to avoid style drift (departures from their stated investment orientation), especially given the importance of retirement funds such as 401k plans to the industry, and the demand of such plans for predictable strategies. Most mutual funds promise to limit their use of short-selling and leverage, and their use of derivatives is highly restricted. In recent years, some so called 130/30 mutual funds have opened, primarily for institutional clients, with prospectuses that explicitly allow for more active short-selling and derivatives positions, but even these have less flexibility than hedge funds.

In contrast, hedge funds may effectively partake in any investment strategy and may act opportunistically as conditions evolve. For this reason, viewing hedge funds as anything remotely like a uniform asset class would be a mistake. Hedge funds by design are empowered to invest in a wide range of investments, with various funds focusing on derivatives, distressed firms, currency speculation, convertible bonds, emerging markets, merger arbitrage, and so on. Other funds may jump from one asset class to another as perceived investment opportunities shift. 

4.    Liquidity:
Hedge funds often impose lock-up periods, that is, periods as long as several years in which investments cannot be withdrawn. Many also employ redemption notices that require investors to provide notice weeks or months in advance of their to redeem funds. These restrictions limit the liquidity of investors but in turn enable the funds to invest in illiquid assets where returns may be higher, without worrying about meeting unanticipated demands for redemptions.

5.    Compensation structure
Hedge funds also differ from mutual funds in their fee structure. Whereas mutual funds assess management fees equal to a fixed percentage of assets, for example, between .5% and 1.5% annually for typical equity funds, hedge funds charge a management fee, usually between 1% and 2% of assets, plus a substantial incentive fee equal to a fraction of any investment profits beyond some benchmark.  The incentive fee typically is 20%, but sometimes higher.

How do hedge funds make money and how is it shared among the employees?

Hedge funds trade in financial markets on behalf of clients in exchange for annual fees, and a cut of the profits. They’re similar to mutual funds but face fewer restrictions on what they can invest in, and can only be used by accredited investors.
The revenue of a hedge fund comes from the fees on the assets it manages. The typical fund charges a fee of 2% of assets under management per year, plus a performance fee. The performance fee is typically 20% of any returns it makes for the clients over and above the 2% base fee. So, if a fund makes 10% returns in a year, then the performance fee is 20% of (10% – 2%), or 1.6% of assets. Adding the base fee brings the total revenue to 3.6% of assets under management.
This means that a $1bn hedge fund returning 10% per year on its investments would have annual revenue of $36m. The clients would receive 6.4% per year on what they put in. These figures are fairly typical. 10% per year is a typical performance target, and similar to what hedge funds actually returned before fees over the last two decades.¹ A few funds charge higher fees and some charge lower ones. Many people think typical fees in the industry have shrunk in recent years.
How is this revenue split between different employees at the fund?

• 20-40% goes to operational costs, including the premises, technology, and operational staff. The larger the fund the lower this percentage.
• About 10% will go to all the junior traders and analysts.
• About 40-55% will go to the senior portfolio manager (who manages the junior traders).
• What remains, 0-30%, goes to the owner of the hedge fund (often also the senior portfolio manager). Many of the costs don’t scale linearly with revenue (i.e. running a $10bn fund isn’t nearly ten times more expensive than running a $1bn fund), so the owner will earn a higher percentage the larger the fund. The percentage is also very sensitive to performance – the owner gets what’s left over after costs, which could easily be negative in a bad year.
• The traders and portfolio managers within the fund are usually paid as a percentage of their returns, typically 10-20%. E.g. if a manager returns 10% in a year, they’ll receive about 1-2% of the assets they manage within the fund. So if they were managing $100m of assets, then they’d earn $1-$2m in that year. In addition they get a base salary, but that will be a small proportion of their total pay (perhaps around $100,000). This means their total pay is very volatile. In some funds, the percentage the traders earn also depends on performance, making pay even more volatile.
• Note there are different compensation structures in different funds and roles (e.g. many quant hedge funds don’t tie pay directly to returns, especially at more junior levels), so this is just a rough guide.

How much do traders actually get?

From the above, we can estimate how much traders earn at each stage. The following is all very rough and could be greatly improved with more data. The extra information about the industry is based on my own judgements having talked to lots of people who work in finance.

• To enter the industry, initially you’ll spend 4-8 years working as an analyst. The ideal path is usually said to be 2-3 years at a top investment bank, then 2-5 years working at a hedge fund as an analyst. In these stages, you’ll be paid typical investment banking salaries (perhaps $100-$300k). An alternative but slower route is to continue in investment banking until you’re known as the best analyst in your sector, then switch.
• After this time, if you manage to progress, you’ll start managing money as a junior trader or portfolio manager. There are many types of trader, but we’re talking about those with significant responsibility for making investment decisions. You might start with $50-$250m of assets under management. So if you successfully earn 10% returns, your income will be $0.6m – $3.8m per year. Of course, there’s a good chance you’ll fail to perform, which would mean earning only your base salary, and could easily lead to losing your job (see next point). Even taking account of the possibility of earning more, because it’s hard to beat the market, a realistic estimate of expected income is probably less than half.
• If you lose money for more than a year, you could easily get fired. How long you have depends on the fund. One or two quarters of bad performance at some funds could already be risky; whereas you might have years at a fund focused on long-term investing. Some quantitative funds rarely fire staff, but let you continue in a more operational role. If you get fired from a top fund, you can usually get a job at a less prestigious fund. If you get fired from a less prestigious fund, you’ll probably have to leave the industry, or switch into a non-trading role. Total turnover varies by fund, but 10-20% is not uncommon for trading roles.
• If you perform well, then the amount you manage can grow rapidly. It’s not uncommon to manage several times as much within a couple of months of starting, though a couple of years is more typical.
• A more senior portfolio manager would manage about $500m-$1bn. If they achieved 10% performance, that would make their pay $6m – $12m per year, though again, average pay is probably less. Moreover, there are probably about 3-10 junior traders per senior trader, suggesting the chance of making it to this level is at most 10-33%. In reality, it’s less since many people leave the industry in the meantime, especially at the more junior levels.
• Note that in some firms, it’s hard to progress from junior trader to portfolio manager, since the managers are recruited directly from banks.
• If you end up owning and managing a hedge fund, then you can earn much more again.
• The owner/senior manager of a $1bn hedge fund which returns 10% p.a. will earn $15 – $25m. However, if the fund fails to return at least a couple of percent they’ll make nothing. If they lose money for more than a couple of years, they could easily go out of business.
• The owner/senior manager of a $10bn hedge fund will make 10-times as much. In fact they’ll probably make even more because many of the costs are fixed, so they get a larger fraction of marginal revenue.
• Of course, very few people make it to this level. A $1bn hedge fund would probably employ tens of traders, suggesting each has only a couple of percent chance of making it to being an owner, even if we ignore those who drop out of the industry.
• Note that some hedge fund managers make more than these figures suggest because they also invest their own money in the fund. The top 5 hedge fund managers usually earn over $1bn in a year. This is because if you already have $10bn and earn a 20% return – which is common among top hedge funds – then you earn $2bn per year.

Much of the above also applies to prop trading. Prop traders trade on behalf of their institution, rather than external clients. They usually exist within small partnerships and banks (though new regulation has reduced the amount of prop trading in banks). Often prop traders trade with a smaller amount of money, but make more aggressive bets. Prop traders typically receive a larger fraction of the returns they make e.g. 30% rather than 10-20%. This means they end up earning a similar amount per year as hedge fund traders.

Sense checks

Looking at the above, and making a very rough estimate, the mean earnings over an entire career in the job could easily be about $400k – $900k per year. This is based on an analyst salary, plus a 10-20% chance of making it as a junior trader, and a couple of percent chance of making it to a top role.
Does that range check out?
We found that the mean income in finance is about $245,000. This includes a wide range of jobs that are mostly much lower earning than trading positions, so it doesn’t seem unreasonable to think that the mean for trading could be several times higher.
We also found that the 99th percentile in finance (i.e. the highest-paid 10,000-20,000 finance workers in the US) earns $1.4m, so are figures are within this bound.
Some hedge funds have to disclose their total compensation, which means you can estimate the average compensation per staff member. Here is an analysis of 15 UK high-frequency hedge funds, which finds mean compensation from $200k-$1.4m. Many of these figures include support staff too, so they are underestimates of the trading salaries. This puts them in line with our estimates. Keep in mind that high-frequency firms generally offer higher pay than hedge funds.
The average employee at a top investment bank earns about $300,000,² but “front office” staff like traders should earn more. The typical front office investment banker age 30 in London earns about $400,000.³ I’d expect hedge fund traders to earn more, so this is in line with the estimates above.

What would the expected earnings be for someone entering the industry?

You’d also need to adjust for the chances of leaving the job. It’s common for people to go into more operational roles, other positions in finance, or entirely different industries, and these all usually have lower income.
You’d also need to adjust for the future prospects of the industry, and other issues we cover here.
Finally, your expected earnings will also be very sensitive to personal fit. If you have a higher than average chance of making it to the top roles, your expected earnings could be many times higher, and vice versa.

Areas for further research

• Make more detailed estimates of the proportion of traders at each level of seniority, and then make a better estimate of the mean.
• Make better estimates of the chances of leaving the industry at each level.
• Cross-check our estimates for each level with more people in the industry.
• Look for more data sources about aggregate earnings (such as industry surveys), and cross-check.
• Make more detailed comparisons with other top earning careers.

Should you “earn to give” in hedge fund trading?

If the mean income of a hedge fund trader is $650,000, then that’s $20m over a 30 year career. If you donated half, that would be enough to cover the salaries of about 5 non-profit CEOs or 2-3 academic researchers, while still having a huge amount left to live on. This is why, if you’re a good fit for an option like this, ‘earning to give’ can be a high-impact career.
Of course, there’s a lot more to say about the pros and cons of earning to give. You can read more in our guide to earning to give.
To find out more about the job, read this interview with a hedge fund trader.