Professional Traders in Hedge Funds
The primary responsibility of a Professional Trader at a Hedge Fund is to safeguard the assets of their investors by generating profits in both up and down markets.
These traders are more commonly referred to as Portfolio Managers or PMs. They oversee Long/Short Portfolios, taking positions based on their investment strategies.
In contrast to Professional Traders at Investment Banks, Hedge Fund PMs do not engage in Market Making activities.
The role of a Hedge Fund PM is largely similar to the Proprietary Trading roles that existed in Investment Banks before the implementation of the Volcker Rule.
Traders at investment banks operate with capital sourced from the bank’s public shareholders, as these banks are publicly traded companies. On the other hand, most Hedge Funds work with capital from private investors.
Key Information About Hedge Funds
The term “Hedge Fund” originates from their typical strategy of maintaining a balanced and diversified portfolio of long and short positions.
A Hedge Fund is essentially an investment structure consisting of a domestic management company and a foreign entity, usually based in the Cayman Islands, that holds the investors’ funds. This arrangement is often formalized through a “Prime Brokerage Agreement” with an investment bank.
The management company usually charges an annual fee, ranging from 1% to 2%, on the Assets Under Management (AUM) to the offshore fund. Additionally, the fund levies an annual performance fee, commonly around 20%, on any profits generated, which is billed to the investors.
Investors often expect the Portfolio Manager (PM) of the Hedge Fund to make an initial investment in the fund and to reinvest approximately half of any earned performance fees back into the fund each year.
Hedge Funds are generally considered to have a more sophisticated trading strategy compared to professional traders at investment banks. This is largely because Hedge Funds are specialized entities with a singular focus. As a result, their trading ideas and risk management protocols must be exceptionally well-crafted to attract investors.
Example of a Hedge Fund Structure
XYZ Fund manages $1 billion in investor capital, referred to as Assets Under Management (AUM). The fund typically maintains 40 long and short positions, which could be a mix of 30 long and 10 short positions or vice versa.
The fund sets its own position limits. In this example, each of the 40 positions could constitute 2.5% of the AUM. Alternatively, the fund might opt for fewer positions with a self-imposed limit of 5% for a single position.
With a 2.5% position size, no individual position in the portfolio can exceed a notional value of $25 million.
Assume that last year, the hedge fund achieved a 20% return with an annualized volatility of 12%.
The fund charges its investors a 2% management fee and a 20% performance fee. This results in $20 million in management fees and an additional $40 million from performance fees (20% of the $200 million profit). Half of the performance fee, or $20 million, is reinvested into the fund.
Expenses for the fund, including infrastructure, basic salaries, and bonuses, amount to $40 million. This is the sum of the $20 million management fee and the $20 million performance fee.
At the start of the next year, the AUM for the fund becomes $1.16 billion, which is the original $1 billion AUM plus the $160 million in net profits.
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