Hedge funds get all the glory... and now they're even going to get all the press, courtesy of the JOBS Act, and I'm more than excited to see who thinks they actually need to advertise to bring in the flows. However, while a hedge fund is structured to make one man insanely rich and a few others relatively wealthy, the Asset Management business has a much wider set of financial outcomes for its employees, and even more for its owners. The purpose of this article is to give you guys an idea of what the business itself really is when we say an Asset Manager or a Hedge Fund. I'll try to go over what makes each different (the basics), how each makes money, and why one may be much more ideal for you than the other, especially early in a career. With that, let's respect our elders, so we'll start with the Asset Managers.

Traditional Asset Management

The standard form of asset management is a long-only strategy designed to offer investors various levels of equity exposure in certain industries, company sizes, and whatever else they may please. In general there's three different types of investors that utilize these services: retail clients via mutual funds, high-net worth individuals via separately-managed accounts, and institutional investors via large dedicated products.

Fees are very straightforward, though they can be tiered by investor type and bulk discounts aren't too uncommon. Generally speaking, the big money gets the lowest fees, meaning the institutional products which make up the majority of the typical firm's AUM aren't paying your typical 1%... more like half of that or slightly more if you're particularly good. Institutional money sends out an RFP to a bunch of different firms they like and you essentially bid on their accounts. All the usual suspects tend to be involved: your big guys like a Fidelity or a T. Rowe, some of the smaller but reputable firms (see my Top Asset Manager thread for more on that), and any specialty firms that might be particularly skilled at the kind of asset class the accounts are trying to invest in. Institutions like pensions, endowments, brokers, private wealth, etc. all are the customers that dominate this portion of the business. This is probably the least sticky of the three businesses, as short-term performance matters most and allocations can be taken away fairly quickly when you start to hit a rough patch.

Mutual funds generally cater to the retail investor as well as the institutions mentioned above. Fees here tend to be around 1% in most cases for actively managed funds, but can be significantly lower with funds that are a lot larger, and south of 15bps in most types of passive fund, usually 10bps and sometimes even lower.

High-net worth is one most places no longer spend much time on, as it's a lot more relationship-driven and tends to be much less sensitive to performance as a result. Clients have much different objectives than your typical institutional money and therefore things are a lot more sticky, fees can be slightly higher, etc. though more and more the industry is seeing high-net move away from being a direct relationship, as financial planners and consultants are making the investing decisions for these individuals and things become a lot more institutionalized and formal.

"models and bottles" isn't the motto here, more like "Flows before Hoes." You can imagine how unbelievably scaleable the business can get once you build AUM. The only real costs of the business are your variable costs on transactions, payments to gatekeepers that distribute funds or act as finders , etc. These variable costs can eat pretty significantly into your take-out, but after the variables are all covered up, assuming something like a weighted average on AUM around 70-75bps, you're probably still left with a cool 20bps for the last big piece of cost... compensation. In a decent-sized fund that would see this kind of breakdown (like my old fund), and by decent-sized I mean something like 30-100B. So if you're running, say, a $50B firm and raking 15bps to comp your analysts and equityholders, that's not all that shabby at $75M. This illustrates the scaleability, given you don't really need to take on any more analysts or pay any meaningful incremental overhead to accommodate another $1B when you're running $50B already... so that 15bps may be $75M to 20 analysts and partners today, but doubling AUM would turn that 15bps into $150M to the same 20 analysts and partners. And that can make those 20 guys pretty rich pretty quick, especially with a better cost structure than the one I've laid out.

The Hedge Fund Model

This one's different and obviously it's not as uniform in structure as asset management because there's way more room for differentiation and the competition isn't as fierce on the fee side as a result of that. Fees work out generally as a management fee that is assessed the same way as an asset manager would, and an incentive/performance fee where the fund gets a percentage of the profits it makes for its investors (over a certain "hurdle rate" in some cases, and only over the fund's high water mark, basically meaning they can't double charge you fees on gains that are really just making up for previous losses). This structure is arguably better for incentivizing money managers, or worse for giving them the incentive to take additional risk so they can rack up huge fees.

Hedge funds do attract some of the same clients as asset managers, but generally you don't invest with a hedge fund unless you are looking for a very different type of strategy (hence the word "hedge" in the name... we can short and that's frequently what they want from you) or even just investors willing to pay up for a brand name manager or to feel savvy because they like the idea of a hedge fund better.

Hedge funds tend to make one man insanely rich, and in most cases funds are very flat across the analyst pool but most/all decisions are made by a single PM or very limited number of PMs. Walking through the dynamics of a $1B fund, things would go like this... in this environment, and without a very distinguished track record and/or superstar managers, you'd be beyond lucky to get the old 2 and 20 fee structure. More normal now in my experience is a 1-1.5% management fee and a 15-20% incentive, though you tend to charge up on smaller accounts and down on larger ones.

So let's say we're running a 1%/20% fund with $1B under management... and let's say we hugged the S&P for the most part and came away with a 20% return last year. We'll get $10M in management fee on our 1%, and 20% of our $200M return, or $40M. So essentially, we've had very little unique outperformance and yet we walked away this year with $50M on $1B with which to pay costs of perhaps 40% of that, and then comp our analysts. Keep in mind our buddies running $50B who probably performed comparably (as they are long-only) or possibly better, are only getting $75M to our $30M on $1B. However, had we lost money, we'd be looking at $10M or maybe even less, and our costs are fixed... so it might be more like all of that (or more) to cover expenses. All the sudden nobody's getting a bonus, rather than 8 analysts all getting a million bucks and the PM walking away with $22M for his 20% year.

With a profile like that, hedge funds are much less about flows and way more about hitting the long ball. One amazing year can make a PM extremely rich, and that's all he needs to basically have enough money to spend in 10 lifetimes. Rather than the "flows before hoes" mantra of the AM industry, this is more like "go big or go home." And like I said, this can sometimes warp manager incentives to the point that they're no longer even investing with the type of strategy their LPs were paying them for in the first place.

So hedge funds have some give and take, and I'm not sure I'd feel all that good about starting one up right now that didn't have someone very established behind it. My gut feeling has been that there is less and less to justify the fees of a hedge fund and, more or less, the types of investors who want to be in hedge funds already are.

Competition in investment management is no different than in any other industry, so it makes sense for fees to trend down over time without some sort of sustainable competitive advantage, right? For hedge funds, that comes in the form of differentiation of some unique strategy (whether it be some algorithm, a large short book, macro exposure, activism, or even just having a superstar that investors perceive as being particularly gifted) as the only way to justify these higher fees. I'll be the first to tell you that my firm, while we do employ activism that makes us somewhat "special," is really no different than a long-only asset manager in a lot of regards, yet our fees are exorbitant in comparison. We could run on the exact same model and still cover our overhead, sure, but given our AUM base is maybe 10% of a standard large asset manager, we really wouldn't be picking up a lot of scratch, and our investment returns would be much less relevant.

Where Do You Fit In?

So which one should you be shooting for? Well, for what it's worth, if I was starting out I'd definitely prefer an established asset manager to an entry-level HF job... and that's even if I was somehow experienced enough right out of undergrad to work at a hedge fund. Asset Management gives you stability that you just won't find at 95% of hedge funds, and your development as an investor will be the primary focus of the research team rather than immediate expectations of concrete performance... unlike hedge funds, AM people don't tend to bounce around a lot (unless maybe at certain "up and out" types of places like Fidelity) and therefore developing young talent becomes infinitely more important than just scooping up experienced hires like HFs want. HFs are very rarely concerned with succession planning... and it couldn't be more different at an asset manager.

Q & A

At the risk of this post being too long and me getting too loopy writing it, I'll answer questions related to this stuff in the comments, so fire away. Please try to stay away from the ridiculous "I'm a _____ major who worked in accounting for a year... do I have a shot at ______?" kind of questions, or at least try and make the question something everyone can benefit from having answered. I'll ignore those "chance me" questions, so apologies in advance.