Hedge Funds vs. Institutional Asset Management: Is a Billion Dollars Really Cooler Than a Million Dollars?

Note: This article was originally posted at Mergers & Inquisitions. You can read the original post here.

Aspiring analysts often tell me that they want to work at a hedge fund one day. The most obvious reason is money.

Starting the next Facebook is way too risky if you want to make a billion dollars, so hedge funds seem like the next best alternative.

And since they’re limited to accredited investors – people with a net worth of at least $1 million or more than $200K of income – you’ve also got that air of exclusivity.

But beyond these points, few people understand the differences between hedge funds and traditional money management – how their investment strategies differ, what it takes to get in, what you do on the job, and what you do afterward.

So let’s dive right in and see whether a billion dollars really is cooler than a million dollars.

Mind-Boggling Money

Certain hedge fund managers make ridiculous amounts of money due to the 2 and 20 fee structure – they receive 2% of their assets under management in fees each year, as well as 20% of the investment returns they generate.

John Paulson made $3.7 billion betting on the collapse of the subprime crisis in 2007 – just compare that to Tiger Woods’ career earnings, which are estimated at only $1 billion.

Tiger would have to play another 40 years like his first 15 years just to match Paulson’s take-home pay in 2007 alone, and he’s arguably the greatest golfer ever.

In good years you’ll see multiple hedge fund managers earning $1 billion in cash – some hedge fund managers even create public profiles to gain a reputation and attract investors (think David Einhorn).

Boring Mutual Funds?

Compared to those paydays, the traditional mutual fund seems quite boring.

But top fund managers there can make a lot of money as well – you just don’t hear about it as much because they’re less public about it and because billion-dollar bonuses don’t happen.

And the flip-side of hedge funds is blowup risk – during the subprime crisis, thousands of hedge funds imploded and investors lost enormous sums of money.

One day you’d be cruising on a yacht and the next you were collecting unemployment.

There’s no way to make billions of dollars in one year without taking huge risks, working 24/7, or being incredibly lucky – and usually you need all 3.

Absolute Returns vs. Relative Returns

The main difference between hedge funds and traditional institutional asset management is that hedge funds focus on absolute returns, whereas money managers focus on relative returns.

It has little to do with investing styles – for example, you’ll see deep value investors at both types of firms.

Imagine you’re a traditional money manager who’s managing to the S&P 500 benchmark in 2008. That year, the S&P 500 fell 37%, but your fund was down “only” 33%. That would be a good year for you, since you’re focused on returns relative to that index.

But that same (33%) return would be awful for a hedge fund – potentially bad enough to shut down the entire fund depending on the leverage used and the assets under management.

Conversely, let’s say it’s 2009 when the S&P was up 26% and both your asset management firm and a hedge fund returned 20%.

That would be a terrible year for you as the relative manager since you’re down 6% against the index, but it would be a great year for the hedge fund manager – who gets 20% of that 20% return (assuming the fund is above its high-water mark).

Breaking Into Asset Management… and Hedge Funds

There are 2 different paths that people follow to work on the buy-side – the IB/PE route and the CFA route. The IB/PE route is more specialized, so let’s start there.

Breaking In from Investment Banking or Private Equity

Some hedge funds like to hire people from IB and PE even though they may not have prior public markets experience – that’s because of the absolute return mandate at hedge funds.

As a result, some funds operate more like PE firms – they just care about finding great stocks to invest in, regardless of what the broader market is doing.

And sometimes they’ll resort to activism if they believe the full value of the company is not being realized (e.g. Ackman with TGT or Lampert with SHLD).

If you want to break in from this background, your main obstacle will be convincing hedge funds (and money managers) that you’re actually interested in the markets.

The recruiting process is similar to breaking into private equity from banking: work at the firm with the best possible brand-name, go through headhunters, network aggressively, and tell a convincing story about how your interests shifted to the public markets over time.

The few ex-bankers I’ve worked with all ended up leaving institutional asset management because they were “deal” guys – they liked doing deals more than they liked following the stock markets, so there wasn’t a good fit.

If you haven’t entered IB/PE yet, but you’re thinking about going to a hedge fund or asset management firm and you’re more interested in the public markets than deals, you probably want to go the CFA route (see below) since that’s a more direct path.

One final note: hedge funds hire people from IB/PE, but traditional asset managers rarely do that for the reasons outlined above.

The CFA Route

Yes, Brian’s favorite topic once again – the CFA.

First, his views here on the CFA are absolutely correct – there’s no reason for a banker to care about the CFA designation because it has little to do with doing deals and selling entire companies.

But if you’re interested in the public markets and not doing deals – whether you want to be in asset management, work at a hedge fund, or go into equity research – then the CFA is almost a requirement.

There are almost 90,000 CFA charter holders worldwide, and the 2 biggest occupation categories are “Portfolio Manager” and “Research Analyst.”

You can even take advantage of networking opportunities within the program by joining local CFA societies – just get a professor to sponsor you and then you can attend society events.

As an undergraduate, joining and attending these events is the single most important thing you can do to break into both types of firms – hedge funds and institutional asset management firms – right out of school.

And yet very few students do it.

But that’s the “path” here – aim for Level 1 of the exam, make sure you network aggressively at those events, start with informal and even unpaid internships at local firms, and use those to work your way in without doing IB/PE first.

If that doesn’t work or you’re already out of school, another option is to go to business school – or even a Master’s in Finance program – after a few years of full-time work experience.

The good news, if you go the MBA route, is that you don’t necessarily need to go to a “target” school to land offers at these firms – that’s in sharp contrast to IB/PE recruiting, which are focused on the top 10-15 programs.

Recruiting – What They’re Looking For

So now you’ve done the networking and you have the experience to break in – how do you impress portfolio managers and land interviews?

Screening

Hedge funds often screen candidates according to who has prior banking or PE experience, but on the long-only asset management side it’s more about your credentials.

The most common requirement there is “MBA and/or CFA preferred.”

You can still get into either industry without these, but it’s tougher and you will have to focus on more specialized funds that match your background exactly.

Personality Traits

Aside from the initial screening, the personality traits required for both hedge funds and asset management are remarkably similar.

The two most important traits are passion for the markets / investing and being a team player.

Passion for the Markets and Investing

Your job as an analyst at either a hedge fund or an asset management firm is to drive investment performance by generating good investment ideas.

We’re not looking for data monkeys to enter data into spreadsheets – we need thinkers who can come up with ideas on their own without much guidance.

This is in sharp contrast to investment banking and private equity, where the bulk of your time is not spent on idea generation or winning clients, but rather on executing deals – at least until you reach more senior levels.

If you’re not passionate about investing, you’ll probably resort to surfing the Internet all day – and the stakes are too high for that to happen.

I hate to quote Wall Street yet again, but this exchange between Gordon Gekko and Bud Fox sums it up:

Gekko: You done good, but you gotta keep doing good. I showed you how the game works, now school’s out.

Bud: Mr. Gekko, I’m there for you 110%.

Gekko: No, no, no, no, you don’t understand. I want to be surprised. Astonish me, pal, new info, don’t care where or how you get it, just get it.

Obviously you want “new info” that is legal and not the material, non-public kind that Bud Fox obtained in the movie.

But just like the quote suggests, you must be a self-starter who can bring great ideas to the PMs – if they have to generate all the ideas themselves, why would they hire you?

Being a Team Player

This sounds so cliché that you’re probably wondering why I’ve even listed it.

In the context of investing, though, being a “team player” is an absolute requirement – teams are tiny, and both hedge funds and asset management firms have PMs with a handful of analysts covering the sector.

It’s not like a Fortune 500 company where there’s so much bureaucracy that getting along with others isn’t required – a person who only cares about himself causes the entire investment process to break down.

But when everyone plays for the same team, it lets HFs and AMs have flatter structures that result in better ideas – and higher payouts for everyone involved.

Do not go into an interview and think that acting like a BSD will get you a job in either one of these industries – this is not like banking where you have rainmakers that can bring in clients with strong solo performances.

Resumes

Your resume needs to demonstrate both of the points above – I often discard good resumes because I see no evidence that the person is interested in investing.

How do you show this?

1. Take investing classes at your school.
2. Participate in or start an investing club.
3. Join your local CFA society and/or start the CFA program.
4. All of the above.

Yes, all the usual criteria like having solid work experience/internships, good grades, and so on still apply but passion for investing is the most important point if you want to work in the public markets.

Interviews

As you might have already guessed, interviews tend to be more like sales & trading than investment banking.

Yes, I may still ask you accounting and valuation questions, but I’m not testing to see whether you’re a financial modeling wizard.

I want to see that you have great investment ideas and can pitch me on why a certain stock, company, or strategy is a smart move.

At hedge funds that operate more like PE firms, you’ll get case studies and modeling tests similar to the ones you see in private equity – but even there, they still care most about your passion for investing and your ideas.

Saying that you’re “interested in business” and talking about companies or business models that you like might work for banking, but it’s a bad, or at least insufficient, way to approach HF and AM interviews – you need to have at least a few investment ideas that you can discuss in-depth.

A Day in the Life – Hedge Funds vs. Asset Management

Once you’re in, the average day is similar at both hedge funds and asset management firms.

You’ll create financial models and analyze financial statements, read sell-side equity research, and talk to management teams of companies – those tasks take up the bulk of your time.

The main difference is that hedge funds have a much, much broader array of investment opportunities than long-only asset management firms.

Asset managers stick to buying or selling stocks, whereas with hedge funds you will see everything from the plain vanilla strategies to more exotic ones involving derivatives, events and special situations, commodities, and so on.

Of course, that freedom also comes with much higher scrutiny on performance at hedge funds – if you screw up and lose a lot of money, you will hear about it and you might be out of a job if it’s bad enough.

As an analyst you’ll work 50-60 hours per week at both these types of firms, with occasional weekend work on top of it.

Another difference on the buy-side is that year-to-date performance impacts your hours – if you get a good start to the year, you’ll spend less time in the office the rest of the year; get in the hole early and you’ll be working much more later on.

In contrast to IB and PE where deals drive your hours, with HFs and AMs performance plays a bigger role.

M&I Note: I left in the 50-60 hours per week reference here, but your hours may be worse than this at the largest and most well-known hedge funds. Similar to PE mega-funds, the culture is more like banking there and you will work. A lot.

The Pay – Hedge Funds

Yes, John Paulson routinely makes billions of dollars each year, but he’s in a completely different league from the average hedge fund manager.

Once you start working at a hedge fund, the average pay might be in the low hundreds of thousands all-in; call it $200K-$400K depending on the fund size, their performance, and your standing there.

That’s a wide range because hedge fund pay is much less standardized than IB/PE pay.

Yes, some people do make over $1 million even at more junior levels but that’s the exception and not the norm – especially post-financial crisis.

You should not expect to make “serious” amounts of money – defined as tens or hundreds of millions in a given year – until you actually become a PM or start your own fund.

If you don’t believe these numbers, look at this hedge fund compensation report from Job Search Digest – over 20% of respondents there reported pay in the $300K – $500K range, with around 10% in the other ranges. The average was $326K.

Fewer than 5% reported pay over $1 million.

The Pay – Institutional Asset Management

While the ceiling at hedge funds is much higher and you see a few outliers each year, the average pay at the entry-level in asset management is not much different from the average entry-level pay at hedge funds.

Greenwich Associates publishes a report on investment management and hedge fund compensation pay each year, and average compensation is in the same range (the actual report is copyrighted, otherwise I would link to it here).

Pay depends more on your title and experience (Chief Investment Officers earn more than Portfolio Managers, who in turn earn more than Directors, Analysts, and Traders) and the fund size than it does on distinctions between different types of firms.

Exit Opportunities

For most people in investment management, “exit opportunities” don’t exist because becoming a Portfolio Manager is the end-game.

Sometimes analysts and PMs bounce around to better opportunities and leave for other funds, but other than that, the most lucrative exit opportunity is to start your own fund.

The key to doing that is getting seed money in the first place – if you’re new to the business, usually that initial investment comes from “friends and relatives” if you happen to have a wealthy family, or from existing PE firms and HFs.

Many PE firms and HFs provide seed money “to invest in start-ups” – Julian Robertson and the Tiger Cubs are the best-known example, but even Blackstone is now investing in start-up hedge funds.

To have a shot at starting your own fund, though, you need to have a great track record and years of high returns elsewhere – yes, “past performance is no guarantee of future results,” but that’s the way the game is played.

So if you’re a sophomore in college right now, don’t even think about this one until you can point to at least 5-10 years of solid returns at funds you’ve worked at.

A Billion Dollars?

A billion dollars is definitely cooler than a million dollars, but you won’t make anything close to that until you’ve been in the game for decades and have become one of the top PMs in the world.

The ceiling is much higher on the hedge fund side, so if the absolute size of your bank account is your top concern, you should go there.

Asset management has a much lower “Beta” but the pay ceiling is also lower – sometimes it’s nice to make a lot of money with much less risk, though.

But if you’re really set on that billion-dollar payday, you might be better off starting the next Facebook and hoping for the best – even if it doesn’t work out quite as well financially, you might at least get a hit movie out of it.