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How Do Hedge Funds Make Money? An Overview

How Do Hedge Funds Make Money?

It is not uncommon to see headlines of hedge funds raking in massive profits in just one year. I feel like every year I am reading a new story about some fund manager getting another billion-dollar paycheck.  It makes people wonder where all the money is coming from. And if hedge funds can generate so much revenue, then how is it determined what piece of the pie the fund gets, and how much the investors get? Luckily for us, the industry has a straightforward formula that makes it easy to understand.

A hedge fund makes money by charging investors. Fund managers will charge investors 2% of the assets under management (AUM) to run the hedge fund. Additionally, funds charge a 20% performance fee if they meet a certain level of profitability in a year. This is known as the two and twenty formula.

What is the Two and Twenty Formula?

The two and twenty formula is an equation for determining how much a hedge fund will charge its shareholders.

The first part of the formula is a two percent management fee calculated based on total assets under management or AUM. For example, if there was a hedge fund with $1 billion in assets, then that fund would charge investors $20 million per year. This 2% will be charged whether the fund made the investors any money or not. The 2% expense ratio goes to administrative overhead costs such as support employees, building space, technology, etc. This fee is so the fund can continue to operate even in years that it loses money.

As far as investment vehicles go, the 2% expense fee is relatively high. For comparison, the actively managed Vanguard PRIMECAP Fund charges an expense ratio of 0.38%. This means that for $1 billion dollars under management, the fund would charge investors $3.8 million. A difference in expensive ratios means that hedge funds are more profitable than other actively managed funds. In some cases, hedge funds can charge their investors even more than 2% going as high as 4%. A higher expense cost means a fund needs to be more profitable to make their investors meaningful and competitive gains.

On top of the 2% expense fee, hedge funds also have another fee commonly known as a performance incentive. This is where the twenty part of the two and twenty formula comes into effect. The performance incentive can be complicated, but in essence, it allows fund managers to be compensated for increasing the profitability of the fund.

Many funds will only charge the 20% performance incentive if the AUM increases in value over a certain predetermined percentage. The increase in value is sometimes referred to as a hurdle rate. Unlike the 2% expense fee, if a hedge fund does not reach the hurdle, then they will not charge their investors. This helps to avoid costing investors money in years when a fund does not perform well.

Another common tool used in determining whether or not a performance incentive will be charged is called a “high-water mark” or “loss carryforward.” These systems require a fund to increase in overall value past any previous year’s record in order to pay its managers. Mechanisms like this ensure that managers are not charging investors when a fund performs poorly.

How Much Do Hedge Funds Make?

If hedge funds are charging these relatively large fees for asset management, then investors have to wonder if they are worth the money. Hedge funds even have required minimum investments which can range from $100,000 to $1 million and beyond. For many people, it is not exactly a small commitment to get into a hedge fund. So how much are these funds making?

According to a MarketWatch article on 2019 hedge fund outflows, hedge funds made $261 billion dollars globally. But while some funds brought huge returns in a single year, other funds sustained large losses, and were forced to close their doors and liquidate. The average rate of return can vary greatly, and sometimes, even when the stock market performs well, hedge funds can underperform as they did in 2019, according to MarketWatch. The average return for hedge fund investors was just 8.64% which was significantly lower than the increase in value of the overall S&P 500 which rose 28.9%.

While the returns for investors was less than what the market had done in the year, hedge fund managers were still handsomely paid. With the top 25 earners making around $20.2 billion in 2019. Hedge funds can be profitable despite what they return to their investors and this can often be directly attributed to the 2 and 20 formula.

How do You Invest in a Hedge Fund?

If you want to invest in a hedge fund, you have to be what the Securities and Exchange Commission (SEC) defines as an “accredited investor.” To be an accredited investor you must meet certain financial thresholds. Some of these thresholds include having a net worth greater than $1 million, earning an income of over $200,000 over a sustained period of time, or by having a trust that is valued at greater than $5 million. As we discussed earlier in the article, to invest in a hedge fund you must have at least the minimum investment amount which can vary from $100,000 to more than $1 million.

It is important to remember that accredited investors have fewer limitations on the types of investment they can purchase because the SEC has defined these investors as more sophisticated. This means that hedge funds, in addition to other types of unregistered investments, are not required to follow the same regulations that other public listings have to. The SEC notes that hedge funds and other types of investments are unique and there is a possibility that investors can lose their entire investment.

To invest in a hedge fund, investors often work with financial advisors to find funds that suit their particular investing goals. A hedge fund also has to be currently accepting investors. After investors find a fund that they want to use, they will have to contact the fund managers and ask what requirements the fund has for investors. These requirements are often similar to the SEC’s definition accredited investors. Once investors have completed all of that, they will have to work with the fund to confirm that they are an accredited investor. This process is not standardized and may include providing documentation of your net worth and debt.

How Do Investors Get Their Money?

If investors want to take their money out of a hedge fund, they will have to work with their fund’s specific withdrawal rules. Many hedge funds have what is known as a “lock-up period.” This is a set amount of time where investors are not allowed to sell or request money from their investments. Hedge funds can have a variety of mechanisms for when investors can request their assets be sold. Some will only let you make a request once every year (or potentially over a longer period), others will only have a lock-up period of 60-90 days. The purpose of the lock-up period is for fund managers to maintain stable portfolios and to improve the liquidity of their holdings. Investors should know the rules around withdrawing from their particular hedge fund before they invest.

Besides the lock-up period, investors will have to work with their funds to manage the sale of their investments. After an investor requests to withdraw an amount or percentage of money, a fund manager will sell the security at whatever the market value is.

Are Hedge Funds Safe?

Just like any other investment vehicles, investors should do their best to understand the risks associated with buying into a fund. This often means consulting a financial advisor. Hedge funds are different than mutual funds or exchange-traded funds because they are not subject to the same kind of regulation that publicly traded indexes and stocks are. In addition to the lack of regulation, fund managers often buy and sell assets more frequently than in a passively managed portfolio. This means that there could be an increased tax liability that investors should be aware of and prepare for. It is possible for hedge funds to be forced to liquidate and close due to heavy losses and in fact the Barclay Hedge website keeps a list of more than 22,000 hedge funds that have had to close their doors for various reasons.

There is no way to tell whether investing in a hedge fund will be safe or not. A lot of fund managers will rely on previous years’ returns to indicate why you should put their money in their fund, but returns are not assured. As with all investing, past performance is not indicative of future profit. So, investors should be wary and speak with licensed financial professionals before making decisions that could cost them hundreds of thousands, or even millions of dollars.

Related Posts

  1. What is a Hedge Fund?
  2. Why Do Hedge Funds Exist?
  3. Why Do Hedge Fund Managers Make So Much Money?
  4. Risks and Rewards of Investing in Hedge Funds
  5. How to Get a Job at a Hedge Fund

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