They were the new Masters of the Universe. By the mid-2000s, hedge-fund managers had pushed aside the old-money bankers by making outsized investments and reaping lavish compensation. They got their name from the practice of hedging, by betting on falling as well as rising prices, something most money managers can’t do. These larger-than-life characters splashed fortunes on ritzy homes, artwork and political campaigns and even spawned a TV series. While some made a killing with well-timed bets, they all raked in fat fees as more savers signed up for the mystique of these “alternative” investments. Then it all went wrong. As the field grew more crowded, many funds struggled to make money, just as near-zero interest rates helped send global stocks on a tear. Investors began to revolt. Now the $3 trillion hedge-fund industry is demonized by critics — ranging from legendary investor Warren Buffett to college students — who claim their hefty fees are a ripoff.
Investors are bailing out of hedge funds or leaning on them to reduce fees. In 2016, more money flowed out than went in for the first time since the financial crisis, with investors yanking $70 billion, or about 2.5 percent of assets. Pension funds in U.S. states including Illinois, New York, Kentucky and Rhode Island have eliminated or reduced their holdings. They followed the biggest one, the California fund known as Calpers, which began to divest in 2014 after concluding hedge funds were too expensive and complex. University endowments, foundations and insurers jumped on the bandwagon, causing more hedge funds to close up shop. Veteran manager Richard Perry, whose fund returned an average of 15 percent a year for decades, threw in the towel, saying his style of investing no longer worked. Eric Mindich, a former trading whiz at Goldman Sachs Group Inc., shuttered his fund, too. In the eight years ending in 2016, hedge funds, on average, produced roughly a quarter of the annual returns on stocks and lagged a broad index of bonds. Some blamed middling performance on low interest rates, computer-driven markets or government regulation. Others got snared in insider-trading scandals. The election of U.S. President Donald Trump lifted returns in the months after he took office and put former hedge-fund managers in powerful roles, including Treasury Secretary Steven Mnuchin.
Some people say John Maynard Keynes was the first hedge-fund manager, making bets on currencies, commodities and stocks in the 1920s and 1930s. Alfred Winslow Jones, who opened his fund in 1949, is considered the first long-short stock manager. Even so, as recently as the 1990s, the public rarely encountered hedge funds, which were primarily investments for the super-rich. Then George Soros broke the Bank of England in 1992 by forcing a devaluation of the pound and John Meriwether nearly started a banking crisis in 1998 after his Long-Term Capital Management lost $4 billion. Hedge funds hit the mainstream in the early 2000s, when institutions began piling in, hoping to preserve capital during market disruptions like the bursting of the technology bubble. The typical fee structure is known as “two-and-twenty” — the fund keeps 20 percent of any profits, plus a 2 percent management fee (more than double the average mutual fund). As hedge funds got larger, managers with mediocre returns routinely earned more from “the two” than they did from investment gains. A product called the “fund of funds” was created so that a bundle of hedge funds could be sold to smaller institutions and a slice of wealthy people known as the mass affluent. These funds usually charge another layer of fees.
Many large institutions, such as Florida’s pension fund, say hedge funds play an important role in diversifying portfolios, since they can reduce volatility and protect against downturns. Hedge funds aim for “absolute return” by trying to deliver “alpha,” or returns that don’t come from the market as a whole. The blowback over performance has been colored by a broader debate about active versus passive management, since low-cost funds that track major stock indexes outperform most human-driven strategies. Buffett has attacked the way hedge funds charge investors, since they typically collect management fees even when performance is poor. “The huge money is in selling people the idea that you can do something magical for them,” he said in May. Most everyone agrees that the number of funds will shrink and fees will drop. One bright spot: Hedge funds using quantitative models, where buying and selling decisions are made by computers, are still attracting money.
The Reference Shelf
- The Showtime drama “Billions” glorifies hedge funds.
- Katherine Burton's 2007 book “Hedge Hunters” explored the investing styles of the industry's pioneers.
- Fund manager Ted Seides wrote about why he lost his bet with Buffett, and why odds are that history won't repeat.
- When Richard Perry walked away from his hedge fund, Bloomberg wrote about his hopes for vindication.
- Warren Buffett stung hedge funds again in his 2017 letter to shareholders.
First published March 3, 2017
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