Background

‘A Positive Force in the American Financial System’*

More than 8,900 hedge funds, or private investment companies, managed more than $1.43 trillion in assets as of June 2009.7 These funds serve an important role in U.S. and global markets, providing qualified investors with opportunities to manage risks and achieve above-average gains. By operating with tremendous flexibility, hedge funds provide liquidity, making financial markets more efficient. Over the past decade, the industry has become more diverse, less leveraged, and more flexible. The innovative investment strategies of private investment companies have strengthened the global competitiveness of the U.S. financial services sector, attracting intellectual and financial capital. As their responsibilities have grown, private investment companies have improved their governance practices, risk-management tools, investor disclosures, and operational infrastructures.

What is a Hedge Fund, or Private Investment Company?

The term “hedge fund” was coined by a Fortune magazine writer in an article about the founder of these investments, Alfred Winslow Jones. It is a term without legal meaning but it generally refers to privately offered, professionally managed pooled investment vehicles.8 “Hedge” (from hedging, or protecting, your investment) derives from the aim of making money, whether a market rises or falls, while managing risk exposure.

Although the term “hedge fund” is widely used, the more accurate phrase is “private investment company” or “pooled investment vehicle.”

Interests in these funds are sold in private offerings primarily to “accredited” investors, specifically institutional investors and “high net worth” individuals.10 A fund pools the monies it receives to invest and then buys a variety of securities and financial instruments. Private placement memoranda may describe investment parameters, terms, and redemption rules, among other things. Institutional investors and/or their advisers typically perform rigorous, ongoing qualitative and quantitative analysis, called “due diligence,” of the fund and its management company. Institutions typically devote an average of seven months to this process and twelve additional weeks to approval, according to a 2008 white paper by the investment consultant SEI.11 (See “Investors’ Rigorous ‘Due Diligence’” on page 20 of the Hedge Funds Primerr)

Hedge funds are as diverse as the managers who run them.12 They may invest in or trade a variety of financial instruments, including stocks, bonds, currencies, futures, options, other derivatives, and physical commodities. Funds that invest primarily in illiquid assets—for example, real estate, venture capital, and private equity—generally are not considered “hedge funds,” although some hedge funds do hold these investments.

Portfolio strategies vary widely and include leverage, short selling, active trading, and arbitrage. Some funds own securities for the long term, using different qualitative and quantitative methods to guide their decisions. Others sell short, meaning they sell shares they do not own and then borrow those shares to complete the transaction. They do so to hedge risks and lock in transaction costs, namely the spread, or the difference between the “bid” and “ask.” (To learn more, visit www.financialdetectives.org.) Some hedge funds are strictly traders, buying and selling securities to capture market inefficiencies and make profits. Still others are “activists,” using an equity position in a company to encourage management to make changes that will increase shareholder value over the long term.13

Even though the assets managed by hedge funds have increased six-fold over the past decade to $1.43 trillion by June 2009, this amount is relatively small in comparison to other major global investment pools. The chart on page four shows that hedge funds represent 1.1 percent of the total funds and assets of financial institutions. Nevertheless, studies show they account for a significant amount of the trading volume in U.S. equities and an even higher share in more complex financial instruments.14

For the eleven-year period from January 1, 1998 through December 31, 2008, the average hedge fund returned 7.45 percent a year (annualized return), compared to a 1.38-percent loss for the Standard & Poor’s 500 Index (with dividends) and a 2.79-percent loss for the FTSE 100 Index, according to Hedge Fund Research, Inc.15 In 2009, the HFR index was up 9.46 percent through June while the S&P 500 rose 3.19 percent.

Hedge funds can protect investments during market downturns. From January 1990 through June 2009, the S&P 500 experienced 36.75 percent negative months, dropping 3.71 percent during these downturns, while hedge funds lost only 0.67 percent during those general market downturns. Over the same time period, hedge funds experienced positive gains in 72.22 percent of the months, compared to 63.25 percent positive months for the S&P 500. Even in one of the worst years for hedge funds, 2008, the broad-based HFRI Fund-Weighted Composite Index fell 18.36 percent, compared to a 38.5-percent drop in the S&P 500, according to Hedge Fund Research, Inc. In 2008, though, approximately 70 percent of hedge funds had lost money. Never before had so many funds lost money. Hedge funds also experienced their widest performance spread in their history in 2008, with the bottom 10 percent losing more than 62 percent and the top 10 percent soaring more than 41 percent.16

Nevertheless, hedge funds can consistently outperform their benchmarks, such as the S&P 500 Index, and are persistent in their outperformance, according to a study issued by the National Bureau of Economic Research in 2006.17 “For every 100 basis points [a basis point is one-hundredth of a percentage point] by which a hedge fund beat its benchmark over a given three-year period, the researchers found, it outperformed that benchmark by 57 basis points, on average over the next three years.”18 This performance advantage “lasts far longer for a hedge fund than it does for a mutual fund,” the researcher told The New York Times. On average, a mutual fund tends to stay a top performer for 12 months or less; often, it then becomes a market laggard.19

As the industry evolved over the past decade, U.S. institutional investors’ demand for alternative investments, including hedge funds, rose steadily.20 This led to rapid growth in both the number of funds and the amount of assets under management, as well as to many changes in the investing styles and strategies employed. With this expansion, the industry became more diverse, innovative, and flexible, while reducing leverage.

Investor nervousness and disappointing hedge fund returns during the 2007–2008 credit crisis led to a sharp decline in new capital inflows, as the industry experienced its largest net capital redemption ever during 2008. Ahead, McKinsey’s Global Institute forecasts a nine-percent yearly increase in hedge fund assets under management through 2013, to $3 trillion, or one-quarter the growth rate that occurred between 2000 and 2007. “The long-term fundamental trends that have driven the industry’s growth so far will likely continue. New money will come from large institutional investors, such as pensions and endowments, increasing their allocations to alternative asset classes; from petrodollar investors seeking higher returns; and, from a growing number of funds of hedge funds, which open up the asset class to less wealthy investors.”21 Surveys of institutional investors in early 2009 forecast similar rates of growth.

Origin of Hedge Funds

The year was 1949 and World War II had just ended. Alfred Winslow Jones, a sociologist, was working on assignment for Fortune magazine, investigating research on stock-market forecasting. Intrigued by the unorthodox investing methods, Jones developed his own approach, a “market neutral” fund. He would buy undervalued securities and short sell other stocks, which provided a hedge against market risk.

Jones was the first to use short selling, leverage, and incentive fees in combination. In 1952, he created the first multi-manager hedge fund. A Fortune magazine article (“The Jones Nobody Keeps Up With”) in 1966 about Jones’s “hedge fund” astonished the investment community with its outperformance. That set off a rush, and, within a few years, the number of hedge funds increased from a handful to more than 100.

Source: Philipp Cottier, Hedge Funds and Managed Futures: Performance, Risks, Strategies, and Use in Investment Portfolios. Bern, Switzerland: Verlag Paul Haupt, 1997. Michael Litt, “Paradigm Shift in Pension & Wealth Management.” American Enterprise Institute, May 12, 2006. Available at: http://www.aei.org/paper/24369.
Relative Size of Hedge Funds

(Trillions of dollars)

Hedge funds as a percent of total: 1.1%

1. Global funds under management second quarter 2009. 2. Pension fund and insurance assets under management are estimates based on 10 percent growth in 2006. Source: Michael R. King and Philipp Maier, “Hedge Funds and Financial Stability: Regulating Prime Brokers Will Mitigate Systemic Risks.” October 30, 2008. Available at: http://ssrn.com/abstract=1297188.. McKinsey Global Institute, Mapping Global Capital Markets: Fifth Annual Report. October 2009. Available by registration at: http://www.mckinsey.com.
Hedge Funds as Pioneers

Hedge funds pioneered many money-management techniques, including:

  • Simultaneous trading in a broad range of markets and financial products
  • Long/short strategies
  • Employing/developing traders’ skills in specific markets
  • Incentive-based fee structures along with owner/manager participation in fund performance
Source: John H. Makin, “Hedge Funds: Origins and Evolution.” American Enterprise Institute. May 15, 2006. Available at: http://www.aei.org/paper/24395
Hedge Fund Attributes
  • They may generate positive returns in rising and falling equity and bond markets.
  • Including hedge funds in a balanced portfolio may reduce overall portfolio risk and volatility and may increase returns.
  • The variety of hedge fund investment styles—many uncorrelated with each other—provides investors with a wide choice of hedge fund strategies to meet their investment objectives.
  • Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.
  • Adding hedge funds to an investment portfolio may provide diversification not otherwise available in traditional investing.
Source: Magnum Funds. Available at: http://www.magnum.com