The 2014 champ Ken Griffin.

Photographer: Patrick T. Fallon/Bloomberg

Rich Hedge Fund Managers Are Still Rich

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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If you have billions of dollars at the beginning of the year, and you invest your money, and the market goes up, then at the end of the year you'll have made hundreds of millions of dollars. This is very obvious, but here is your annual reminder of it, dressed up as overpaid hedge fund managers:

For investors in hedge funds, like big pension funds, 2014 was not a lucrative year. But for those who managed their money, the pay was spectacular.

The top 25 hedge fund managers reaped $11.62 billion in compensation in 2014, according to an annual ranking to be published on Tuesday by Institutional Investor’s Alpha magazine.

This is not especially true, though, for ordinary uses of the word "compensation." Here is how Institutional Investor describes its methodology:

To estimate a hedge fund manager's total earnings for one year, we draw from two components. As always, Institutional Investor's Alpha counts the individual's share of a firm's management and performance fees. The management fees often add up to a sizable sum at the largest firms, many of which charge between 2 and 5 percent. We also count the gains on the individual's own capital in their funds, which can be considerable. If a manager still has not reached his high-water mark, we count just management fees and the gains on his personal capital for the year.

Emphasis added. Most of this "compensation" is not "compensation," in the sense of amounts that pension funds paid these guys to manage their money. Most of it is just return on capital: The managers had money in their funds, and the funds went up, so the managers had more money at the end of the year than at the beginning. They invested a lot of money reasonably successfully, so now they have more money.

Here's my rough dumb decomposition of the top 10, along the same line as last year's :

And here that is in dollars:

The gray bars are (roughly!) the returns on the managers' hedge funds: If the managers had just put all their money in their own funds, they would have earned those amounts even without charging any fees. The blue bars are the amounts the managers actually earned (in percent of their wealth, or in dollars). The blue bars are bigger than the gray bars, mostly. But the gray bars make up the bulk of the money. The top 10 hedge fund managers made $8.23 billion in 2014, of which $5.76 billion (70 percent) looks like just return on their own capital and $2.47 billion (30 percent) does not.

By this standard Warren Buffett was paid $15.5 billion in 2014, almost twice as much as all of the top 10 hedge fund managers combined. Of course, he beat the S&P 500, and not all of them did. Some credit funds, for instance, underperformed the S&P 500 index of large-cap stocks, which I suppose is a relevant comparison? 

So I mean look: The best-paid hedge fund managers do seem to have been paid pretty well. Even subtracting returns on their own funds, several of them seem to have made hundreds of millions of dollars from fee income. But most of the best-paid hedge fund managers aren't getting richer mainly by being paid to manage hedge funds, just like Warren Buffett's wealth is not mainly driven by his $100,000 salary at Berkshire Hathaway. They got rich initially by being paid to manage hedge funds -- mostly because they did a good job of it -- but their income now comes mostly from having a lot of money and investing it. As I said when we talked about this list last year, they live in a Pikettian world where returns on capital outstrip returns to labor.

What else should we think about this list? One thing to consider is alignment of incentives. There's a stereotype that small hedge funds live on their performance fees, so they are hungry and motivated: A 2 percent management fee on a small amount of money is a very small amount of money, so to keep the lights on and send the kids to sailing camp you need to make your 20 percent performance fee as big as possible. Big hedge funds, on the other hand, can live comfortably on their management fees, because 2 percent of a lot of money is still a lot of money. So you'd expect them to be more conservative asset gatherers, and less inclined to chase performance, relative to smaller funds.

And then there are the "best paid" hedge funds, where the manager has billions of dollars invested in his own fund. He's not living on management fees or performance fees; the main determinant of his earnings -- um,"earnings" -- for the year is not how much he charges but just how much he returns on his own money. The classic hedge-fund-manager 2-and-20 fee structure is swamped, for him, by his personal investment.  In some ways this is an ideal alignment of incentives: The manager participates alongside his investors, rather than getting paid mostly in an option on their returns (performance fees) or a flat cut of assets (management fees).

But "hedge funds are a compensation scheme masquerading as an asset class," and maybe there's some value in the compensation scheme itself. If you are looking to hedge funds for outsize returns, you might want to pay your manager an option on your returns, by giving him a performance fee of 20 percent of the upside and limited penalties on the downside. Options increase in value with volatility, and giving a manager asymmetric rewards might encourage desirable risk-taking. That might be exactly what you want if you're a pension fund investing a small chunk of your portfolio with hedge funds in order to earn above-market returns. On the other hand, if your manager is already a billionaire investing a big percentage of his net worth alongside you, he might be more conservative with your money than you are, or than you want. It's probably more important for him to stay a billionaire than to rack up more money.

Of course, there's no reason to think that the main use of hedge funds is to get above-equity-market returns. Presumably no one is investing with Ray Dalio, the creator of "risk parity" investing, because they want him to beat the S&P 500 in a bull market. You might very well invest in a hedge fund to reduce or diversify your risks, rather than to beat the stock market. And a billionaire who relies less on performance fees and more on his own capital might be just the guy to do that for you.

The New York Times article on the "best paid" managers goes on:

That collective payday came even as hedge funds, once high-octane money makers, returned on average low-single digits. In comparison, the benchmark Standard & Poor’s 500-stock index posted a gain of 13.68 percent last year when reinvested dividends were included.

Perhaps that's just a sign of maturity in the industry. The richest hedge fund managers have made a lot of money. Now they want to keep it.

  1. Last year's effort is here. Methodology:

    1. Hedge fund manager earnings for 2014 come from the Institutional Investor's Alpha list.
    2. Hedge fund managers' wealth comes from Forbes profiles.
    3. I subtract 2014 earnings (step 1) from current wealth (step 2) to get wealth as of the start of 2014, which good lord is not scientific.
    4. Hedge fund returns for 2014 come from the New York Times and Institutional Investor's Alpha articles about the hedge fund list, plus this Bloomberg ranking. When multiple funds were listed in the Times and Alpha articles, I just averaged their returns.
    5. Then the expected amounts (gray bars) are just (a) fund returns, in percent and (b) fund returns times starting wealth, in dollars.
    6. And the actual amounts (blue bars) are just (a) Alpha reported earnings divided by starting wealth, in percent and (b) Alpha reported earnings, in dollars.

    I used the top 10 just because they're in the ungated Institutional Investor's Alpha article, plus it's easier than doing 25.

  2. If they're not, it could be because (1) the manager is not fully invested in his fund, (2) the manager runs multiple funds and is invested in funds that are different from, or weighted differently from, the funds I use in the calculations, (3) my data is wrong, (4) etc.

  3. That is: Buffett owns 321,000 A shares of Berkshire Hathaway and just over 2 million B shares. They were worth $177,900 and $118.56 per share, respectively, at the start of 2014, and $226,000 and $150.15 at the end. That's a $15.5 billion change in wealth (from $57.35 to $72.85 billion). Buffett also got a $100,000 salary, which must have been nice for him. I owe the Buffett example to Nat Stewart on Twitter.

  4. Though of course he has a staff, and that staff is probably more levered to the fee scheme than the boss is.

  5. I mean, that's a general loss aversion model. Presumably actual billionaire hedge fund managers are less risk-averse than, say, I would be if you gave me a billion dollars. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Stacey Shick at sshick@bloomberg.net