27 March 2018

If you’re moving to a hedge fund for the money, you’re probably making a mistake

You’ve finally made it to the buy side. You’ve convinced somebody that you’re ready to step up and put real capital to work. The real question now is, do you get the orange Lamborghini or the white one?

Like you, I was once naive. I remember being so excited when I got my first buy side job. I seriously thought my biggest problem was going to be finding ways to spend all the money I was going to make. And if you spoke with the PM who hired me, you’d think the same thing. But here’s what they don’t tell you until after you’re hired.

Assets and returns are always below expectations

When I first joined, I was told my team would run $2bn in capital and would generate 5% returns. That sounded amazing to me. A 5% return on $2bn is $100m dollars! I wasn’t sure what my percentage of that $100m would be, but even if I got 1%, that’s a million dollars. That works for me!

Well, the question you should be asking is how consistently does the team run $2bn in capital and how consistently has it returned 5%? From what I’ve seen, teams generally run a lot less than the allocated capital because they’ll take off trades that work there’s always a shortage of new trades to replace them. 5% is easy to generate if you’re long-only. It’s much harder to generate when you’re running a low-vol, market neutral, factor neutral strategy.

Fees, fees, fees

They say banks are designed to make many people millionaires, while a hedge fund is designed to make one person a billionaire. I’m going to give you a hint: that person is not you. Hedge funds aren’t charities. They’re not paying your salary or that of your team out of goodwill. Trading costs aren’t free, either. Neither is the cost of capital, or those expensive trips to see management teams. All these costs add up and are deducted from your P&L. Suddenly, what you thought was a decent return has gotten much smaller. It varies by firm, but it’s not unreasonable to assume 1% of P&L will be deducted just from fees alone.

Netting risk

Nobody told me about netting risk until well after I was hired. Let’s say you crush it working at a hedge fund. There’s a good chance you’re on a team that covers more than one sector. Now assume those other sectors lost money, offsetting all your profits. So your team has a net P&L of $0. It’s great that you did a fantastic job, but with a P&L of $0, there’s no money to pay anybody. This may not just apply to your team. If you have a great year but your firm doesn’t, you may not get paid either. So not only do you need to make money, which is not easy, but you need to make money in the same year as the rest of your team and firm if you really want to get paid!

Attribution

There are two truths to the buy side: 1) Everybody thinks they’re a better investor than they actually are, and 2) everybody is greedy. When you start off on the buy side, your PM is going to discount the value you add to the team. That trade that made a ton of money last year? He thought of it and he’s the one who put it on; you just did the modeling work. PMs will pay you the least amount possible without forcing you to quit. Having been on the buy side for many years now, you’ll never really be happy with what you’re paid, but you’re not going to be scraping by either. Unless you get that Lamborghini.

Margin of Saving was created by an analyst at a multi-billion dollar hedge fund to help others learn how to invest and save.