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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