A hedge fund can invest in almost any opportunity, in any market, where it foresees potential profits at low risk. While hedge fund strategies vary enormously, most hedge against market downturns and, indeed, the primary purpose of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.
Most hedge funds are not, despite a common misconception, volatile nor do they use a great deal of leverage. The misconception stems from, as described by Investopia:
[R]ecent history, which began with the headline-making collapse of Long Term Capital Management in 1998 and continued with the sensational meltdown of the Tiger Funds in March of 2000, followed by the reorganization of the once high-flying Quantum Fund in April of 2000. These high-profile incidents overshadow more than half a century of hedge fund history that began when Alfred Winslow Jones launched the first hedge fund in 1949.
Fortune magazine reporter Alfred Winslow Jones became the “father’” of the hedge fund industry when, in 1949, he committed $40,000 of his own money, raised an additional $60,000, and began investing in stocks for long term holding while, at the same time, short selling other stocks. This innovation is now known as the classic long/short equities model.
Initially Jones’ hedge fund model incorporated a general partnership, but in 1952, changes were made including the formation of limited partnerships and the incorporation of a 20% compensation fee structure (based on profits) to incentivize the fund’s managing partner to enhance the fund’s performance. With these changes in place, along with the long/short equities model, using some leverage, Jones had created something unique, etching his name into investment history as the father of the hedge fund.
The hedge approach was a major contender right out of the gate and soon outperformed mutual funds by 85% from 1962 to 1966, attracting the attention of high net worth individuals. By 1968, at least 140 hedge funds had sprung up in the U.S. Additionally, high profile money managers moved into the space because of the compensation structure.
The boom didn’t last, however, as hedge funds began moving away from Jones’ model and into one that used long-term leverage methods rather than choosing stocks and hedging them against risk. As a result, many hedge funds had little protection against market fluctuations and the industry began seeing losses, most significantly during the bear market of 1973-74, which led to many funds closing permanently.
Toward the end of that same decade, however, hedge funds began grow, albeit quietly, as only a handful were still active. New firms did form, of course. One of the more well known, Tiger Management Group, was formed in 1980, by stock broker Julian Robertson and no one could touch him for stock picking acumen. Roberton’s Midas touch grew Tiger to $7.2 billion by 1996 and led the way for a hedge fund industry comeback.
However, Robertson’s play-it-safe approach kept him from investing in the technology boom of the 1990’s and consequently Tiger dwindled until the fund was finally closed in 2000. Ironically enough, the Internet bubble, and additionally the equity bubble, burst in 2000 damaging many of the more aggressive firms that had outperformed Tiger.
Hedge funds had historically been largely under the radar of regulatory scrutiny because they had been predominately contained to private investments. However, following the bursting of the Internet bubble, the Securities and Exchange Commission stepped in and, in 2004, required hedge fund managers and sponsors to register as investment advisors under the Investment Advisor’s Act of 1940. Among other things, the new requirements mandated that hedge funds firms keep up-to-date performance records, hire compliance officers and create a standard of ethics.
The financial/housing crisis of 2008 came after the merger-and-acquisitions market had rebounded nicely in the years following the bursting of the Internet bubble, though merger arbitrage (a strategy practiced by many hedge funds) has still not recovered. Hedge funds, today, have grown to be one of the largest segments of the investment management industry with more than $1 trillion in assets under management. Yet, this could be just the tip of an iceberg. According to Todd Lashway, managing director of Fairfield, Iowa-based Capital Management Partners Inc, “Potentially, one of the most significant changes in the hedge fund industry is occurring right now with the ability of hedge funds to publicly advertise. In the past, hedge funds were offered as private placements only. Now, the new SEC rules for the marketing of hedge funds are expected lead to an even faster expansion of the industry.”
Today, it is estimated that there are over 10,000 hedge funds in existence, according to Hedge Fund Research, not including “funds of funds” a hybrid whereby investors put money into a fund that invests in multiple hedge funds and are more easily accessible to the ‘average’ accredited investor.
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Judy Radler Cohen is a financial editor and investigative reporter. Since 2007, she has worked with business publications and websites, including Global Finance magazine, eFinancialCareers.com and Wantedtech.com. Judy spent over a decade as editor of Mergers & Acquisitions Report where she managed weekly production, generated story ideas about all facets of capital markets and investigated/wrote…
The Potential of Hedge Fund Returns: Evaluating Risk and Reward
Evaluating Future Hedge Fund Returns: Beyond the Numbers
Three Ways to Drastically Improve Portfolio Performance with Hedge Funds Based on Your Financial Goals
Rethinking Hedge Fund Performance and Fees
Episode 85 with Todd Ryden
Episode 72 with Pete Hecht
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