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Hedge Fund Bosses Make Too Much? Get Used to It

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Hedge funds are back in the headlines, thanks mainly to the release of Institutional Investor’s Alpha magazine annual report on the earnings of top hedge fund owners and managers. The Hedge Fund Rich List includes such well-known luminaries as Citadel’s Ken Griffin, Bridgewater’s Ray Dalio and Renaissance Technologies’ Jim Simons. Together, the top 25 are reported to have taken home about $13 billion last year.

As AQR Capital Management chief Cliff Asness points out, this list isn’t a good guide to the fortunes of hedge-fund managers in general, because it selects only the top earners. Since hedge fund returns can vary a lot, and since performance fees are a substantial piece of hedge fund owners’ earnings, there will always be some names to fill out an eye-popping Top 10 list.

But what the list clearly does show is that hedge fund moguls’ earnings are often divorced from the performance of their funds. Kevin Drum of Mother Jones alerted me to a particularly striking example:

Michael Platt, the founder of BlueCrest Capital Management, took home $260 million…It was a difficult year for his firm…He lost investors in his flagship fund 0.63 percent over the year and then told them he was throwing in the towel.

This offers a key insight into how hedge fund fortunes work. As Asness notes, most so-called managers are really hedge fund owners, who make money because they own a lot of the equity in their businesses. When their business profits, they profit. And hedge fund company profits are not the same thing as the performance of the funds themselves. Quite different, in fact.

See, hedge funds aren’t entirely based on performance. Like most asset managers, they also earn management fees -- a slice of their investors’ total wealth that gets lopped off every year no matter how well the fund does. Hedge fund management fees are uncommonly high. Whereas a typical wealth manager will gobble up 1 percent of investors’ assets every year, hedge funds are famous for taking closer to 2 percent -- that’s the “2” in the famous “2 and 20.” The 20 is the 20 percent performance fee.

That little 2 often matters much, much more than the great big 20. Imagine a  hedge fund that manages $100 million of investor wealth, and charges 2-and-20. Suppose the fund goes up by 5 percent, or $5 million. The performance fee will be $1 million, or 20 percent of $5 million. The management fee will be about $2 million, or 2 percent of $100 million. Overall, the investors will make $2 million, or a 2 percent return after fees, while the fund managers take home $3 million.

Now imagine what happens if the fund instead loses money, as funds often do. If the fund declines 5 percent, and there’s full clawback (negative performance fee) of previously earned performance fees , then the managers will lose $1 million. But the 2 percent management fee is still in effect, so they get about $2 million from that, for a net profit of roughly $1 million. Meanwhile, the investors lose an overall amount of about $6 million, including the management fee, for a total return of negative 6 percent.

So we see that the profits of a hedge fund business are very, very different from the returns on the fund itself. It’s all about the management fee.

In recent years, management fees have become more important to hedge fund profits, for two reasons. First, performance fees have fallen, while management fees have been pretty steady. Here, via Bloomberg Gadfly’s Michael P. Regan, is a graph of how fees have evolved since 2004:

Second, as we saw in the previous example, management fees matter more when returns are lower. And hedge-fund returns have been low in recent years. Here is the Mizuho-Eurekahedge asset-weighted index of hedge-fund returns during the past decade:

As you can see, the index hasn't gained much since mid-2011, reflecting very low returns for the hedge-fund industry as a whole. That means most of the money must have been made via management fees. That doesn’t apply to many of the people on Institutional Investors’ Alpha’s Top 25 list, since those people mostly had very high performance, and hence high performance fees. But it almost certainly does apply to a few, like Michael Platt. Persistently high management fees mean that hedge fund owners can make vast fortunes despite years of underwhelming results.

One of the great complaints about hedge funds is that managers get a huge break via the carried interest loophole,  which taxes performance fees at a much lower rate than earned income.  But closing this loophole won’t do much to reduce these vast fortunes, since performance fees have fallen for so many managers. Meanwhile, management fees are already taxed at ordinary income rates.

If you think hedge fund billionaires as a group make too much money, well, get used to it. Until people stop paying hedge funds gigantic management fees, they will continue to amass vast wealth.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net