Hedgies have a certain stereotypical image as portrayed by the press. That image is typically a male about 40-70 years old making hundreds of millions or billions of dollars a year. This sells newspapers and lexus'.
The truth while nice is not as grandiose. Depending on whose database you follow, there are 8-12,000 hedge funds globally. The term hedge fund itself is elastic enough to basically include anyone, who will place a bet on anything on someone else' behalf and charge 2 & 20 for the privilege.
Here is a little data. Hedge funds success is like movie, sports etc. success in that a few do extremely well and most do fairly well. The average (median hedgie) doesn't own or probably even lease a plane. Note the data below most likely overstates incomes and returns due to survivorship and reporting bias which is significant in most hedge fund databases. They are marketing tools after all.
Here is a break down using the Tass database over time. One can see the evolution of a cottage industry paying white collar professional level salaries and then exploding. More recent data would be interesting to see. I have included the spreadsheet Download HedgeFund Data gogerty dot com I built for those interested in playing with assumptions behind the data. Also note that some funds have a hurdle rate which may downplay the income more.
If anyone is interested in chatting about what makes a fund a more "successful business" drop me a line. Getting more AUM (assets under management) is the goal of most funds.
The magic threshold in this business is $100m AUM with +36 months of operations because these are the levels where most institutions start looking at making allocations. Instituional sales cycles for allocations are estimated at 9-12 months, while family offices are estimated at 12-18 months. Establishing trust takes time.
From an institutional perspective funds under the $100m AUM level are mostly noise. As a hedge fund operator this means you chase high nets, feeders and those specialized in emerging managers etc. which means lots of due diligence for smaller allocations.
The business of a hedge fund is managing the investing process, managing the back office processes and sales in that order. Growing and maintaining AUM is about establishing trust and faith in all the funds ongoing processes. Hanging the shingle out with a sharpe ratio alone draws attention, but doesn't close the sale.
The back-office operations need to be stable and in place for real money to show up.
Return and Risk at the business level of hedge funds are as important as return and risk at the trading/allocation level of running the business.
Having top quartile risk adjusted returns is a good start. Pros want to know about risk, ie. after verifying the apparent stability of the returns on the money, the need to verify the return of the money. Fashions come and go in various hedge fund sectors, but as a manager it is best to stick to your knitting. Offering a 100/130 product for a long short value fund may work, but moving from value to convert arb is a stretch.
Mature back offices, SMA (separately managed accounts), operational stability and experience as well as lots of checks and balances are vital to the allocators due diligence process.
The more transparent all processes in a fund, the more successful it should be. There are a few black box exceptions to this rule, but trust in process and people is vital to a funds survival. Trust is built with more than logos with Greek columns and names that end in Capital. Some of my favorite funds are the value based ones that put out newsletters or presentations extolling the thinking behind their positions. Greenlight and Pershing Square are good examples of this.
Madoff was avoided by many banks who didn't understand the process he claimed to use. Acknowledging and then acting on ones ignorance is a powerful thing. If you don't understand it move on. "not getting it" may not be cool, but it is wise. Know thyself.
Another potential benefit of having investors understand about your funds operational and investment process is that they are more likely to stick around during tough times. Many fund's revenue declined this year relative to previous years even though performance may have been extraordinary even adjusting for high water marks. Redemptions reflect a lack of faith. This lack of faith can be related to many of your funds aspects, don't make them your people or your processes.
Revenue adjusted for performance probably declined for hedges funds in 08-09 due to skittish investors who sold the "lows" of the fund. Research into hedge funds and mutual funds shows the median investor under-performs the funds they invest in, due to buying high and selling low.
If someone doesn't have faith in your funds processes, then they are betting on your last month or quarter etc. This isn't any way to build a stable business.
I advocate transparency and openness wherever possible for a fund or fund of funds as it helps to retain clients. The risk in transparency is that it shows a lot of these funds or FoF's for the smoke and mirrors marketing machines that many are. Some black boxes in this business are black because they are full of junk, see Galleon, Madoff etc.
One could argue Buffet runs a hedge fund with an open structure that makes him immune to capital calls, this allows him to retain cash at the most interesting times and to compound returns, without having to change the rules of the game midstream such as putting up gates etc.
Running a small business, be it a hedge fund or dry cleaner is about trust and process building with employees, customers and anyone else who comes into contact with your firm. Low trust or strong alpha male power based cultures should be avoided at all times. Bullshit and bravado are often bedfellows that rarely build stable lasting enterprises. As an investor I would seek funds with questioning & listening cultures rather than posing and posturing cultures.
About the charts above: my cost assumptions are for a small fund with 3 full-time employees, a basic master feeder structure, no marketing payouts and outsourced legal, accounting and reporting functions in small office. The incomes may be over stated by 20-40% due to high water marks, redemption flows, survivorship & reporting biases and start up costs.