Hedge Fund vs. Asset Management

Hedge funds and traditional asset management firms operate under starkly different business models, despite both being in the business of managing other people’s money. 

They may seem similar on the surface, but their approaches to generating profits and growing their businesses are almost diametrically opposed. 

This article will explore these differences, understanding why hedge funds often remain relatively small while traditional asset managers aim for substantial growth.

Key Takeaways – Hedge Fund vs. Asset Management

• Hedge funds aim to optimize performance while asset managers aim for asset growth.
• This leads to hedge funds capping their size at a certain level and passive asset managers looking to almost perpetually grow.
• Day traders and other tactical traders can learn from these differences to balance their strategies.
  • For example, using index-based approaches for a portion of their portfolio to benefit from market-wide growth without capacity constraints. 
  • For their active trading strategies, they should be mindful of transaction costs and recognize that certain strategies may have limited scalability, potentially becoming less effective as trade sizes increase.

The Traditional Asset Management Model: Asset Growth

Traditional asset management firms, such as mutual fund companies, typically follow a straightforward business model: charge a fixed fee based on the assets under management (AUM).

This fee structure creates a strong incentive to grow AUM as much as possible, as it directly correlates with the firm’s revenue.

Example

For example, a traditional fund might charge 60 basis points (0.60%) on AUM. 

With $1 billion under management, this would generate $6 million in annual revenue. 

To increase profits, the firm must attract more assets, either through marketing efforts or by delivering strong performance that attracts new investors.

This model benefits from economies of scale.

As AUM grows, the cost of managing each additional dollar decreases (assuming the strategy is passive or nearly passive), leading to higher profit margins.

Moreover, many traditional strategies, such as index funds or large-cap equity funds, have virtually unlimited capacity, allowing firms to manage tens or even hundreds of billions of dollars.

A few firms (e.g., Vanguard, Blackrock) manage trillions of dollars.

In short, they’re focused on market-based beta returns.

The Hedge Fund Model: Performance

Hedge funds, on the other hand, operate under a fundamentally different paradigm.

Their fee structure typically consists of two components:

• a management fee (often 2% of AUM) and
• a performance fee (commonly 20% of profits)

This structure aligns the fund’s interests more closely with those of its investors, as a significant portion of the fund’s income is tied directly to performance.

Unlike traditional asset managers, successful hedge funds often face capacity constraints.

Alpha is a zero-sum game. It’s hard with small amounts of money and becomes even harder with large amounts of money.

Their strategies may rely on market inefficiencies or specific opportunities that become less profitable as more capital is deployed.

As a result, hedge funds often have an optimal size beyond which returns may diminish.

Example

Consider a hedge fund that can generate $100 million in annual profits.

With $500 million in AUM, this represents a 20% return.

The fund would earn $10 million in management fees (2% of $500 million) plus $20 million in performance fees (20% of $100 million), totaling $30 million in revenue.

After subtracting operating costs, the fund managers might clear a substantial profit assuming they keep them in check.

Growing AUM doesn’t necessarily benefit the hedge fund managers. If they were to double their AUM to $1 billion without increasing total profits, their return would drop to 10%. 

While management fees would increase, performance fees could decrease if there are hurdle rate considerations (e.g., investors get the first 6% of annual returns for free, or they get the index’s returns for free) or there are higher operating costs for managing more money (e.g., more investor relations hires), potentially resulting in lower overall revenue for the managers.

This dynamic creates an interesting incentive structure where hedge fund managers often seek to optimize their AUM rather than maximize it. 

Some highly successful funds even return capital to investors or close to new investments to maintain their ability to generate high returns.

Combining Both Models

Some firms effectively combine both business models.

AQR and Bridgewater Associates, for example, operate traditional hedge fund strategies, but they also manage a substantial amount of assets in more traditional, lower-fee strategies.

This dual approach allows them to benefit from the high returns and performance fees of its hedge fund operations while also generating steady income from its larger pool of traditionally managed assets.

Implications

Understanding these different business models is important for investors considering where to allocate their capital.

It’s also important for traders, investors, and capital allocators in understanding exactly what type of business model or approach they want to use.

Traditional asset management firms offer broad market exposure and typically lower fees, making them suitable for long-term, passive investment strategies.

Their size can provide stability and liquidity, but may limit their ability to significantly outperform the market.

Hedge funds, conversely, offer the potential for higher returns and strategies that are ideally uncorrelated with broader market movements.

Nonetheless, they come with higher fees and often require substantial minimum investments with lockup periods.

Their focus on performance can lead to outsized returns in good years, but also carries the risk of large losses.

Conclusion

While both hedge funds and traditional asset managers try to grow investors’ wealth, their approaches to achieving this goal and structuring their businesses differ significantly.

Traditional managers seek to amass assets, benefiting from economies of scale, while hedge funds often prioritize performance, even if it means limiting their size.