Hedge Funds Explained (According to a Hedge Fund Analyst)

Hedge funds, an area of finance that very few people knew much about just a couple of years ago, have started to relatively recently get more attention from the general public. Still, not too much is known about the secretive industry, besides the fact that these jobs are some of the highest paid on Earth. Prominent hedge fund managers have billion dollar plus net worths, and even some junior analysts in their 20s have compensation bumping up close to 1 million dollars per year.

In this video, I'm going to go over the secrets of the hedge fund industry, including how these funds make money, why so many of their owners are billionaires, and even how junior analysts are able to be so highly paid. And what exactly makes me qualified to talk about the hedge fund industry? Well, I actually work as an investment analyst at one. Now let's get into the video.

Names such as Ray Dalio and his firm Bridgewater, Ken Griffin and his firm Citadel, and Bill Ackman and his fund Pershing Square all have become household names over the past few years. However, I think it's important to note that not all hedge funds are created equal. The term hedge fund is sort of a catch-all term for any sort of fund that raises money from what I refer to as institutional investors, as well as high net worth individuals. These institutional investors include groups such as pension funds, university endowments, and even insurance companies. All of these various groups give money to hedge funds for one reason: to generate even more money for them in the form of investment returns.

So, with that background, let's now go into the different types of hedge funds out there because each category of hedge fund has drastically different approaches to investing. Here are five different categories of hedge funds.

The first category of hedge funds I want to talk about are called long-short funds. This is definitely the most famous, or infamous, depending on who you ask type of hedge fund. A long-short hedge fund will take long positions in stocks that they anticipate will go up while, at the same time, shorting stocks that they believe will go down in value. The goal of this strategy is to be able to profit whether the broad stock market goes up or whether it goes down. In the ideal situation, a hedge fund would be able to make money on both sides of the trade, with the price of the stock that they have a long position in increasing while, at the same time, the price of the stock they have shorted decreasing.

This is really the type of investing that hedge funds get their name from. The word hedge in investing is an investment position intended to offset potential losses or gains that may be incurred by another investment. I know that's not the most simple explanation, so let me use an example of a long-short trade. Let's say a hedge fund goes long General Motors stock and, at the same time, goes short Ford stock. By going short Ford stock, the hedge fund is essentially hedging their General Motors long position.

Let's say the entire auto industry starts to struggle, and all of the auto companies, General Motors and Ford included, start to struggle, and their stock prices decline. Since the hedge fund was long GM, they lost money on this investment as GM's stock price declined. However, since the fund was also short Ford, the fund made money as Ford's price fell. So, even though the hedge fund lost money on its long position since its investment in General Motors was hedged by a short position in Ford, the total loss was decreased, because losses on the General Motors long position were offset by gains on the Ford short position.

Now, of course, this is a simplified example, but it gives you a better understanding of how a long-short hedge fund works. One of the reasons why long-short hedge funds are attractive to large investors like pension funds is because many investors feel like long-short hedge funds provide them with some protection during a market crash. If you had all of your money in an S&P 500 index fund and it fell by 50 percent, your portfolio would be down 50. However, the hope investors have with long-short funds is that under the same scenario of a 50 percent market decline, the short positions that the long-short hedge fund has would make money, leading to a smaller overall loss for the portfolio.

An example of a well-known long-short hedge fund is Melvin Capital. Melvin Capital got a ton of attention last year during the GameStop fiasco when they shorted the stock, betting on it to go down. However, what happened next demonstrated the risk of being a long-short hedge fund and in shorting stocks in general. Unfortunately for Melvin, GameStop's stock price shot up rapidly, causing them to lose a ton of money. At its height, on January 28th, the short squeeze caused GameStop's stock price to reach a value of over $500—nearly 30 times the stock's valuation at the beginning of the month. This caused Melvin Capital to post a return during that three-month period of negative 49 percent.

Even though, in theory, it seems like long-short investing can reduce risk, it actually can be quite risky if not done properly. Before we move on, I want to talk about what hedge fund managers are doing after hours, as these guys live and breathe alpha. They're always looking to capitalize on frontier asset classes. So it made total sense to me when I learned that a lot of these people are heavily invested in physical art. I mean, why not? It's expensive, highbrow, and has exhibited a very interesting risk-return profile. In fact, 10 to 30 percent of ultra-high net worth individuals invest in art.

Well, now you can invest in art like those hedge fund managers— all thanks to Masterworks, the sponsor of today's video. Now, why would I invest with Masterworks? Well, contemporary art pieces outpace the S&P 500 total return by 164 percent from 1995 to 2021. Here's how Masterworks works: they acquire high-end paintings and securitize them by filing a public offering with the SEC. This allows investors like you and me to allocate a portion of our portfolio to fine art as easily as we could add Apple or Tesla stocks. Getting started with Masterworks is super easy. You just visit their website, create an account, and add one of the most stable asset classes around to your investment portfolio. You can gain priority access by clicking my link in the description, and it also really supports the channel, so go check it out.

Now, let's get back into the video. This is a perfect segue into the next category of hedge funds that I want to talk about: long-only. As the name suggests, these funds only take long positions and do very little to no shorting of stocks. Additionally, something else that is worth noting is that long-only funds tend to have a longer-term perspective when investing than their long-short counterparts.

Generally speaking, hedge funds are referred to on Wall Street as fast money. Of course, there are exceptions, but usually this means that they are jumping in and out of stocks, and their investment timelines can be pretty short—somewhere in the range of three to six months, and sometimes even shorter. Compare this to long-only funds, where usually the investment timelines are over a year. One prominent investor actually got his start at what would today be considered a long-only hedge fund. That person is none other than Warren Buffett. His first investing job after college was working as an investment analyst for his mentor, Benjamin Graham, author of the book "The Intelligent Investor." Buffett went on to start his own fund, the Buffett Partnership, that took money from investors and invested that money in a relatively concentrated portfolio of stocks without any short positions.

So I guess you could say that makes Buffett one of the first prominent hedge fund managers, even though he really made his name as the CEO of Berkshire Hathaway. The next type of hedge funds is quantitative, more commonly referred to as quant hedge funds. A quant hedge fund uses quantitative analysis to select securities. This means that the fund relies on research and mathematical and statistical modeling to predict how an investment will perform. Traditional hedge funds, often referred to as fundamental hedge funds, base their investment strategies on fundamental research and human intuition. A quant fund, on the other hand, removes the human element and relies entirely on mathematical and statistical modeling. Workers at quant hedge funds are usually less typical finance borough kind of people and more often have computer science or software engineering backgrounds.

Next up we have activist hedge funds. Now we couldn't go a whole video about hedge funds without mentioning Bill Ackman. His fund, Pershing Square, is considered to be an activist hedge fund. These are a type of hedge fund that most frequently make the news, and for good reason. These activist funds have a pretty similar strategy: they identify a company that is not performing as well as the activist hedge fund thinks it can. It usually has something to do with how the company is being run by its CEO and board members. That activist fund buys a lot of stock in the company since the more stock you own in a company, the more say you have, and management usually has no choice but to listen to the activist fund if they own enough shares.

The activist hedge fund then proposes a list of suggestions, maybe better called demands, about things the company should do to boost its stock price. This can include selling itself to a bigger company, selling a small part of the company, or making some operational change, including sometimes replacing the CEO. As you can imagine, this whole process can get pretty messy and dramatic, and that's why activist hedge fund managers get a ton of media attention during this process.

The last type of hedge fund I want to talk about are called macroeconomic hedge funds, or just macro hedge funds for short. An example of this type of hedge fund would be Ray Dalio and his firm Bridgewater Associates. Global macro hedge funds make investment choices based on the broad economic and political outlooks for various countries. So, generally speaking, most hedge funds are focused on analyzing one particular company—for example, is Apple stock going to go up or down—while macro hedge funds are more focused on a specific result of international economic or political issues.

The best way to think about this is that macro hedge funds approach investing from a more high-level view instead of just focusing necessarily on one particular company or industry. So now we get into the really fun part: how hedge funds make their money. And let me tell you, if a hedge fund does it right, it can make a ton of money. That explains why, if you look at a list of the world's wealthiest people, a decent amount of them made their money from hedge funds.

Once you see the business model behind hedge funds, you will see why. What is so impressive about the hedge fund business model is how hedge funds are able to make so much money with relatively very few people. A hedge fund can make hundreds of millions of dollars a year with a pretty small team. The money that the fund earns can increase dramatically as the fund's performance increases, all while keeping the number of employees the same. Compare that to pretty much any other business where usually there is a direct relationship between growing your sales and the number of employees you have.

This means that as your sales grow, so do the number of employees you have to pay. So, for example, in the case of a restaurant, as a restaurant expands into new locations, each location has to hire new workers and pay those workers. With hedge funds, on the other hand, a hedge fund can scale up how much money it makes with the same number of employees. This makes each employee at the firm more valuable if they are able to generate strong returns and ultimately more revenue for the fund.

With a hedge fund, a fund can make hundreds of millions or even billions of dollars in profit with enough people to barely fill a movie theater. This is why people that work at hedge funds get paid so much. The hedge fund industry operates under a revenue model referred to as "two and twenty." This is where a hedge fund gets two percent of their assets under management (AUM for short) each year as a management fee, as well as twenty percent of all profits.

Let's show how the structure works using an example. Let's say a hedge fund is managing ten billion dollars of money they are investing on behalf of clients. Each year, the hedge fund is going to get two percent of that 10 billion dollars as a management fee. This means, in our example, the hedge fund would make 200 million dollars just for turning the lights on. Additionally, the hedge fund also has a performance-based fee where they get twenty percent of all the profits they make throughout the year. So, let's say the hedge fund is able to generate a ten percent return that year. This means that the hedge fund made one billion dollars in investment returns for its clients, calculated by taking the ten billion dollars the fund manages and multiplying it by the investment return of ten percent.

The hedge fund gets twenty percent of that one billion dollars in investment returns. This means the hedge fund will make another 200 million dollars from its performance fees. Over the course of the year, the hedge fund will have made 200 million dollars in management fees and another 200 million dollars in performance fees, bringing the total fees for that year to 400 million dollars.

But what if the hedge fund is able to generate 20 percent returns instead of the original 10 percent returns we talked about? This means that they will have generated two billion dollars in investment returns that year and, yep, they get 20 percent of that. So their performance-based fee for that year would be 400 million dollars. Add on that 200 million dollars of management fees from the two percent we talked about earlier, and the hedge fund will have generated 600 million dollars in fees for the year.

This leads to probably the most interesting question in this whole video: how much does an investment analyst make at a hedge fund? As you can imagine, most of the fees that a hedge fund generates go to the people at the very top. This is why so many hedge fund managers consistently rank among the world's wealthiest people and are the ones you see buying professional sports teams. However, please don't shed any tears for the junior employees; they are far from going hungry.

Speaking from my experience, straight out of college, working as an investment analyst at a hedge fund, you will be making over one hundred thousand dollars a year, with most first-year employees making somewhere between one hundred fifty thousand dollars to two hundred thousand dollars. If you are working at a top hedge fund that had a strong year, your compensation could even fall somewhere between four hundred thousand dollars and six hundred thousand dollars— even for someone fresh out of college.

One interesting data point to note is, according to a survey of research analysts at hedge funds, the average compensation for a research analyst in the United States is around six hundred seventy-five thousand dollars a year. It's important to note that a significant amount of this compensation comes in the form of a bonus. In most jobs, the end-of-year bonus is usually only a few percent of the base salary, maybe up to 10 or 20 percent of the base salary in certain industries. That's not at all how it works in the hedge fund industry. Bonuses can be 100, 150, 200, and even at more senior levels, 300 percent of your base salary.

At the end of the year, that six hundred seventy-five thousand dollar average salary that I mentioned earlier breaks down to around one hundred seventy-five thousand dollars of base salary, with the other five hundred thousand dollars coming in the form of your year-end bonus. This is highly dependent both on your personal performance as an investor as well as the performance of your fund. If you or your fund had a bad year, that bonus number could be a big fat zero.

Transitioning to the more senior investors referred to as portfolio managers, they can expect to make north of one point four million dollars per year. And then, of course, the founders and head portfolio managers, such as the Ray Dalios and Bill Ackmans of the world, routinely see their compensation cross the one billion dollars a year mark. Typically, people working at hedge funds went to a top university and also worked in investment banking. For me personally, I had a summer internship at a well-known investment bank and then was able to use that experience to land a job as an investment analyst directly out of college.

However, I would say it's more common for someone to work at an investment bank such as Goldman Sachs, JPMorgan, and Morgan Stanley for a couple of years and then make the switch to working at a hedge fund. In terms of hours, it is extremely variable, but very far from a nine to five. I would say on average I personally work around sixty hours a week, but that is on average. Some weeks it can be as low as fifty, but during what is referred to as earnings season, when companies release their quarterly earnings, that could ramp up to seventy hours a week, if not more.

So, there we have it. If you have any more questions about the hedge fund industry, leave them in the comments below, and I will try my best to answer them for you guys. As always, thanks for watching. Make sure to like this video and subscribe to the Investor Center if you aren't already. Talk to you next time.