How to (not) get rich managing a hedge fund

Topic: the economics of running a hedge fund

How much money do you need to manage in a hedge fund?

Let’s say you manage to raise 100 million dollars from friends and family. How far would that get you?

Revenues

Fixed fee: 1% of 100m = 1 million dollars a year

Performance fee: 20% of whatever your “outperformance” is, which depends on what you’ve promised, and if you have some catching up to do relative your high water mark or other promises.

We’ll leave that part for later, since you can’t really count on reliably amassing performance fees. On average fund managers don’t add any value relative their benchmarks, so on average fund managers can’t expect to get any performance fees.

Costs

Staff: 3 people (you, a partner, and one more for research and administrative work) at 150k$ each a year, which would be considered the bare minimum for running a 100m$ fund and attracting decent talent. 3*150=450k$.

In Sweden the cost of 150k$/yr amounts to less than 10k$/month (95k SEK) per employee before taxes but after social services fees. The take home pay for the employee after personal taxes will be around 5.5k$/month (55k SEK)

Travel expenses (eight trips per employee/yr to attend conferences, visit important companies, clients etc. NB just two trips per quarter, and at a cost of just 2k$ per trip for a few hotel nights, airplane tickets and expenses): 8*2k$*3 = 50k$

Premises: 50k$ per year for an average office in the CBD district

Equipment, computers, mobile phones: 2k$/yr per employee = 2*3=6k$ (could just as well be rounded to zero)

Information and trading systems, 3rd party research: 50k$ per employee = 3*50 = 150k$ (NB: the cost could easily run to twice that)

Regulatory fees, expenses, insurance, securities custody etc.: 0.1% of AUM = 0.1%*100m$ = 100k$ (could easily be twice as much)

Total costs: 450+50+50+6 (rounded to zero)+150+100 => 800k$ (or up to 1m$ depending on information costs nd regulatory expenses)

Income

Income before performance fees and taxes: 1 000k – 800k =200k$ (or as little as zero)

Income after taxes (25%) per employee (3): 200 * (1-25%) /3 =50k$ (or zero)

Bonuses and dividends

The above example leaves just about no room for bonuses, and thus little chance of retaining high quality employees (including yourself). In addition if you can’t perform good enough for a performance fee, even your friends and family will jump ship before long.

Let’s say you outperform your threshold by 5-10 percentage points, how far would that get us?

Performance fees for 5-10pp outperformance: 20%*5%*100m = 1m$, and 20%*10%*100m = 2m$.  That would leave 750k – 1.5m$ after taxes for distribution to the owners, or a decent 250-500k$ each in dividends that year. Now, I wouldn’t get my hopes up too much for repeating such a performance year after year.

In addition you’d run the risk of falling behind during difficult years. While struggling to catch up there could be periods of no performance fees in sight for years at a time. What if your fund lost just half of what the market lost in the crashes of 2002 and 2008? Even with such stellar performance, you’d still need 3-5 years per crash to catch up before earning variable fees again. Most actually give up altogether, after losing more than 20% from their high watermark.

Conclusion

Even a 100m$ hedge fund is more or less a break even operation, where its founders or employees get a basic annual compensation but no frills. The upside consists mostly of soft factors, like independence and freedom, plus the potential for landing a few lucky big years before enduring a crash. If, however, the order is reversed they get nothing extra.

Please note that if you simply had 5m$ of your own and made a 10% return, without the hassle of running a hedge fund (clients, authorities, regulations…), you’d net a clean half million dollars for yourself. In Sweden that would be after taxes, since personal capital gains are tax free here.

Running a billion dollar hedge fund or bigger is a whole different game. We, e.g.,  managed our +1B$ fund with more or less the same crew as when it was a tenth that size.

At fixed fees of +10m$ a year and performance fees of typically at least as much, and total costs before bonuses, taxes and dividends, of around 2m$, there was plenty to go around for us four principal owners. Now, try a 10B$ fund on for size in terms of its economics!

What ever happened to all the perma bears?

We all live in a yellow perma bull, yellow perma bull! Bull market in the sky with diamonds! …markets that grow so incredibly high…

All you need is bull
All you need is bull, bull

Bull is all you need

To cut the cheese, there never were any perma bears to begin with.

Yes, you read that right. No matter what you might have heard, there has never been such a thing as a perma bear. You’d better check your sources.

There are of course quite a few people using that term, as if it meant something. Those people typically fall into one of the following categories:

Perma bulls:just buy and hold the best companies forever” (at any price); these guys disappear with the next downturn never to be seen again. Some of them bought Broadcom, Worldcom and March1 on margin in the year 2000. Others had five mortgages in 2007. Yet others were all in the XIV ETF (inverse volatility)

Newbies: they are simply parroting a meme their broker, or similarly clueless friend, told them. They have no idea what they are alking about, what a perma bear or perma bull might be even in theory.

Failed short sellers, that failed because they didn’t do any real research or succumbeed due to sloppy risk management

The average retail investors have never even contemplated going short anything, although a few have dabbled in buying a few puts or selling calls to add some “Las Vegas” to their “portfolio” (of one single stock; either a 100m$ pre-revenue biotech company, or whichever stock is the most written about [Tesla, Theranos, Enron] or having appreciated the most (FANG stocks).

Normal portfolio managers in mutual funds aren’t even allowed to go short.

That leaves more or less only sophisticated and experienced investors on the short side. Most of them are hedge fund managers that already have successful investing careers behind them. Some, admittedly, might be rich brats that think “shorting the hell out of bad companies” is a better pick up line, than letting their zero maintenance dividend kings take care of themselves while going all in on hookers and E on a yacht.

Anyway, these sophisticated investors typically made their money mostly being long good investments, thus per definition can’t be perma bears. Or they are extremely good at sniffing out good clean shorts.

In any case, if they are that good at researching and investing, there is zero probability they will limit themselves to being short only, when there are so many more things to go long with less risk and less scrupulous opponents than when selling things short.

In other words, only smart people become short sellers. The idea doesn’t even occur to average people. And if it did, Joe would soon lose everything and give up, or re-emerge as first a cautious, later a raging bull (only to lose it all again of course).

The smart(ish) short sellers are smart enough to know there are two sides of every story, of every market. Hell, they are more or less the only ones who realize there are two sides.

I have yet to meet or even hear about a real perma bear, an investor who is forever and always only a seller of all things. That’t because they simply don’t exist. “Perma bear” is something n00bs and mostly perma bulls call people they don’t understand and are afraid of: investors with more money and experience than themselves that dare go against the crowd and look a little silly for a while, because they have good reasons to trust their mind more than the crowd’s blind stampeding.

It’s been a a hard bull’s night,

and I’ve been working like a bear

So, whenever you hearthey’re a perma bear,” check your and their premises. You just might pick up something important and useful.

Just remember that there are no perma bears; and experienced and knowledgeable investors who dare stick their neck out against the crowd, against CEOs, against the Fed and other authorities to reveal relevant information, put both their money and reputation on the line for no other reason that their superior vantage point allows them to identify a higher probability of making money going short than buying blindly.

Tell me that you want the kind of things,
That bulls just can’t buy,
I don’t care too much for bulls.
Bulls can’t buy me love.

The Future Skills Program

The most important thing in life is your health. Health starts with sleeping well. Actually, without it you’ll die (Why We Sleep, Matthew Walker).

Sleep, like food, is one of very few things evolution just can’t get rid of. Despite the huge downsides to lying unconscious and defenseless in nature among predators and parasites, humans on average do it one third of their lives.

The Health And Financial Freedom loop

In order to control your time enough to sleep the way you’re intended to, you need financial freedom, lest there will always be a boss or a client making demands on your time when optimally you’d be sleeping or playing.

Further, attaining economic independence through a specialist, entrepreneurial, leadership or investment career in a world of accelerating technological development means you need as agile a mind as possible.

Enter sleep and play:

Research done during mainly the last two decades (c.f. the amazing books “The Real Happy Pill” and “Why We Sleep”) increasingly show the importance of regular exercise and sleeping well for strenghtening our cognitive capabilities (coping with stress, anxiety and depression, increasing your focus, memory, creativity, and happiness; and combating and postponing dementia). Proper nutrition, not least for promoting a healthy and diverse microbiome, is also an important part of shaping a future proof and capable mind-body machine.

So you can see how you need sleep and exercise to boost your financial standing; and economic independence to optimize your sleeping habits and general health.

Creating the Future Skills Program

Since I left the finance industry (I was a portfolio manager at a very successful hedge fund for 15 years: Futuris – The European Hedge Fund Of The Decade), I’ve spent a considerable amount of time thinking about what made Futuris not just great, but the greatest money manager in Europe for a full decade.

From the Future Skills Program (Finance Module)

Over the last year, I’ve finally come around to distilling my investment insights into a series of videos, with accompanying detailed course notes and exercises.

Three decades of investing lessons and best practices distilled

In the Future Skills Program, I explain the investment methodology and practices I’ve honed during the last 30 years.

They include what I’ve picked up from business school (M.Sc. in Finance at SSE 1990-1994), as a financial analyst specializing in IT and investment companies (1994-2000), as a portfolio manager (2000-2015) with focus on software, services and finance, and finally as a private equity investor 2015-2019.

From the Future Skills Program (Finance Module)

A robust health, sound decision management practices and career planning are as integral to designing a good life as investing prowess. Therefore, I and my partners have put together a complete Future Skills Program, including chapters about networking and career advice, value investing and personal development. I’m in charge of the Advanced Career (6) and Finance videos (16).

Please note that I’ve hesitated to participate in creating this course. All the topics discussed are complex matters without simple answers. The course details what you need to work on and in what direction to focus your energy, but you’re still the one having to put in the dedication and work.

We can only show you the door, but it is you who have to walk through it.

If you’re ready to take real responsibility for your life, career, risk management and finances, check out the course program in detail here: