What are hedge funds, and what social functions do they serve?

(Published in prettier formatting on Medium.)

J. Pierpont Morgan died in 1913 with a fortune of about $1.5 billion in today’s dollars. For his sway over Wall Street he was nicknamed “Jupiter,” after the Roman king of the gods.

In 2013, four hedge fund managers took home over $2 billion as income each, with the top manager pocketing $3.5 billion. How did a few asset managers earn more money in a single year than Pierpont Morgan did in his whole life?

It’s not always easy to tell. Hedge funds are secretive firms that have long invited suspicion. Their activities have provoked no less than Bill Clinton, who bemoaned the undue power of “a bunch of fucking bond traders” whose whims determined the success of his policy programs.

What should you know about the industry? This essay discusses how hedge funds are structured and the role they play in the financial system.

What are hedge funds?

Hedge funds are pooled-investment vehicles that are relatively unconstrained in their methods of generating returns. They can be thought of as small mutual funds which face fewer regulatory burdens and invest in less conventional ways.

The hedge fund industry has about $4 trillion in assets under management, which is significant, but not so large that it can dictate to the rest of Wall Street. Consider the fact that BlackRock, an asset management company, has about $4.3 trillion under management alone.

What makes a company a hedge fund?

Hedge funds are legally prohibited from advertising themselves to the public, and are allowed only to raise funds from government-approved “accredited investors.” These investors must prove a certain net worth and go through a registration process to become accredited.

In exchange for this limitation on raising capital, hedge funds face relatively little regulatory scrutiny, with few restrictions on the assets they can trade and the leverage they can employ.

The very first hedge funds distinguished themselves by employing leverage and short-selling. That means that some of their trades were made with borrowed capital, which magnified their returns; and that instead of holding on to a stock and waiting for it to rise, they bet that the price would fall.

These two practices, though, have long stopped being sufficient to distinguish hedge funds from other investment vehicles. Modern hedge funds trade all sorts of securities more exotic than standard stocks and bonds. And aside from long/short strategies, their styles have become more sophisticated by orders of magnitude; that includes investing in distressed assets, mergers arbitrage, quantitative investing, and much more.

2-and-20: The very high fees of hedge funds

Hedge funds are pioneers in many ways, including in the very high compensation scheme they set up for themselves.

Claiming inspiration from the Phoenician merchants who took for themselves a fifth of the profits of a successful sea voyage, the very first hedge fund kept 20% of the profits of a trade, as well as 2% of the total assets under management. That’s terrifically expensive given that passive index funds may charge you something like 0.2% of your assets, with zero extra charge for profits.

This “2-and-20” model is remarkably persistent across hedge funds, so much so that a law professor has argued that instead of as specialized investment vehicles, hedge funds should be understood as “a compensation scheme masquerading as an asset class.”

In addition to high fees, investors in hedge funds must tolerate another cost. Hedge funds typically make it difficult for investors to withdraw money on short notice. So investors have to agree not to touch their capital, locking it up for a while after they invest, and sometimes over certain periods determined at the manager’s discretion. These contractual restrictions can have dramatic effects for managers and investors; depending on when these restrictions are exercised, investors may not pull out of a bad position, or they pull out too early and contribute to the failure of a good trade.

How well do hedge funds perform?

It’s important to note that the term “hedge fund” should not connote “investment firm of market-beating returns,” just as the term “hedge fund manager” does not necessarily mean “asset manager with extraordinary insight.” A hedge fund is mostly a legal class. Someone with little capital or experience in investing can incorporate as his very own hedge fund: All he needs is a business license. There’s no particular reason to believe that the mere act of incorporation turns a newbie into a skilled investor.

Though there are some very high-performing firms that have generated astonishing returns, hedge funds as a class do not seem to be able to consistently beat the market, especially when fees are accounted for. There are no guarantees that buying into just any hedge fund will earn you very high returns.

Which hedge funds are notable, and who manages them?

One of the first investors who resembled the modern macro trader was the economist John Maynard Keynes. Keynes used leverage and went both long and short on currencies, bonds, and stocks while he managed the endowment for King’s College, Cambridge.

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Michael Lewis on the difference between gambling and investing

The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet (you losing all of your money in hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of “investing” is “gambling with the odds in your favor.”

Michael Lewis, The Big Short.

Thinking Differently: Tyler Cowen interviews Temple Grandin

Tyler Cowen has conducted excellent interviews with Peter Singer and Ralph Nader. Here’s a very short e-book that’s basically a raw transcript of his conversation with Temple Grandin, the slaughterhouse designer and autism researcher who is herself autistic.

Besides the overview on autism what really struck out was how Cowen kept trying to make more general observations about the neurodiverse, and Grandin’s general reluctance to venture into the abstract.

Here are some excerpts:

On what autistic people tend to be good and bad at:

Cowen: In academia, where both of us reside, there are a lot of autistics. And there are other places in our economy where autistics are more likely to flourish than others: library science, the appraisal of paintings, work that requires pattern recognition or fine attention to detail.

Grandin: There are two things that autistics tend to be really bad at. And the [first] thing is, high-level jobs do not require multitasking, having to do two different things at once. The other thing that we’re very bad at is following long strings of verbal instructions. Those seem to be two things that are really quite universal.

Cowen: This notion that the people who do well are the mild cases and the people who don’t do well are the severe cases, I tend not to agree with that.

On autistics and paternalism:

Cowen: Let’s say you want to smoke marijuana – and that affects only you – that’s against the law. I think an autistic person is more likely to be suspicious of paternalism… But is it possible that autistic people are, in some sense, too suspicious of paternalism – that there are examples, maybe, where paternalism would do the world some good, but autistic people, because of their history and, maybe, basic inclination will resist that paternalism because that resistance has become almost ingrained?

Grandin: I have to sell my work and not myself. I can remember early in my career, going to an agricultural engineering meeting and everybody thought I was really, really super weird. And then I whip out a copy of my drawings that I had done, of a cattle-handling facility and they go, “Wow, you drew that?” And as soon as they found that I had drawn that, they started to give me some respect. You know, people respect ability.

Cowen: Maybe ten years ago, I would have thought that over time we’ll tinker with the genes of the human race and this is likely to be a good thing.  But my attitude is changing and I fear if we tinker with genes or use selective abortion, that the result will be we’ll get a lot of kids who are easy to raise or, maybe they’re tall and blonde and captain of the football team, but we’ll lose a lot of diversity.

Cowen: As we go back to the Stone Age and ask, why did autism genes ever survive? That’s an unanswered question… I think one possibility is, during times of urbanization, these autistic people had fewer social contacts and maybe they were less prone to pandemics.

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A simple exercise to improve your writing

Try this out:

Re-type an article you really like.

Almost any article will do. Ideally it’s a good piece of writing, but really the only requirement is that you  like it.

Here’s how to start:

Find an article by someone whose writing skills you admire and whom perhaps you want to imitate. If it’s a magazine, lay it out in front of your laptop and re-type the article. If it’s online, open up a notepad or a Google Doc, put it beside the article, and start typing.

It’s a fun and simple way to improve as a writer.

Why? You notice things when you re-type. You get a sense of the choices a writer makes in diction and syntax; you see how they move between sentences and paragraphs; you figure out how to hyphenate, and the right way to use semicolons after all. You see all of the things that your eyes used to glide over. Even small things like where a comma is placed becomes incredibly important.

It doesn’t have to be a whole article. Just take your favorite few paragraphs and re-type them.

Don’t know where to look? Try out a long piece from the New Yorker. There are some terrifically gifted writers there. Plus, its archive of the last few years is free this summer.

Or, try re-typing the work of a reporter. They usually write clearly and matter-of-factly. Radley Balko is a master of clarity, on the level of both individual sentences and also in terms of structure.

Go for it. It’s fun. Not only will you enjoy re-reading your favorite passages again, you’ll have a better sense of how the magic came together.