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What are hedge funds, and what social functions do they serve?
- _random_ 12y agoWhat is the social function of Google's tax evasion?
- basseq 12y agoNotes and errata: Simple answer to the question posed in paragraph two ("How did a few asset managers earn more money in a single year than Pierpont Morgan did in his whole life?"): inflation. ($1.5B in 1913 is about $36B today.) Threshold for becoming an accredited investor is $200k annual income or $1M net worth. Particularly interesting is the overlap between hedge funds and VC investors / angels, considering the similarities.
- danwyd 12y agoFirst sentence: "a fortune of about $1.5 billion in today’s dollars."
- scrumper 12y agoThe author says that J. P. Morgan's estate was worth $1.5bn in 2014 dollars, not in 1913 dollars.
- basseq 12y agoApologies: I stand corrected.
- Sniperfish 12y agoSpeculation only, but I'd expect the relative size and scope of the financial industry today vs 1913 to explain that difference. As in it's easier to earn $1.5bn within 2013's financial industry than it would have been (inflation adjusted) in 1913.
- vasilipupkin 12y agoNote that in 1913 U.S. economy as a whole was probably 20 times smaller, even after adjusting for inflation. So, JP Morgan had a relatively big chunk of money as a percentage of real gdp
- auntienomen 12y agoMoreover, capital was far scarcer then than now. If you needed to raise money for an enterprise, there were fewer places to look for it. Consequently, Ol' Pierpont had a great deal more politial power than someone with the same amount of cash might today.
- deleted 12y ago[deleted]
- aetherson 12y agoYeah, this is more or less right. Inflation adjustments measure how much you have to spend to consume a given amount -- so, basically, if a loaf of bread costs $0.02 in 1913 and $2.00 in 2014, then inflation is 100x. With lots of complexity in there as well, of course. Notably, what inflation isn't is something like "percentage of total size of the economy." So if the economy expands (as it has), then the amount of money available to be made in something that scales to the size of the economy (like the financial markets) increases well beyond the pace of inflation. In 1913, the US population was about 1/3rd what it is now. The US now plays a much more significant role in the world economy, and of course technological advancement has increased the size of the economy as well. Inflation doesn't account for any of that per se.
- ihsw 12y agoThank you for changing the title -- the reasoning for such a title is spurious at best, which likely was this single notable line: > They’re more secretive; they’re less constricted in the trades they’re allowed to make; and they say they hire the best people working with the best technology. Which applies to pretty much every leading technology company just as well, or start-up flush with free money.
- danwyd 12y agoFairy long article. Here's the summary: Hedge funds are investment vehicles that have avoided being heavily-regulated because they only accept money from government-certified "accredited investors." Their investment strategies are secret and unconventional. Some of them deliver floods, while the average one doesn't do that well. Hedge funds provide liquidity, which makes it easier to trade; and conduct arbitrage, so that prices are muscled into line before they get totally irrational. (The latter doesn't always work though.) Meanwhile, since they have fewer safety nets, hedge funds are more aggressive about monitoring their own risk. They're better than banks in that respect, which are much more heavily leveraged and which have a history of being supported by the government when they mess up. Hedge funds have never been bailed out by the government like banks have time and again.
- digikata 12y agoIf their investment strategies are secret, then how do we know that hedge funds haven't been bailed out by governments - at least indirectly? The secrecy makes it more difficult to evaluate if public policy could have been steered by politically connected hedge funds.
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- thingylab 12y ago1. There is no relationship whatsoever between the secrecy of their strategies and the likelihood of a government bailout. Most companies have some sort of proprietary secrets, after all. 2. They are no more secretive than the average private company. In fact, this is largely a myth, as is the belief that hedge funds are "lightly regulated". You can in fact find a lot of information about a fund by spending five minutes on the SEC website.
- bradleyjg 12y agoWe know they've been bailed out indirectly. Among other mechanisms: as counterparties to bailed out banks, as money market investors, and as holders of corporate and GSE debt.
- deleted 12y ago[deleted]
- muhfuhkuh 12y agoYou know, it unnerves me how forceful and imperative you are about it. In the authors opinion, hedge funds do serve a social purpose: To regulate volatile markets via arbitrage, preventing bubbles on the high end and undervaluation on the low end. You can't just enforce an arbitrary rule on something as subjective as semantics.
- scrumper 12y ago> Social is an useless word to include, and only invokes trolls to argue. Some irony there. Author addresses the point well: read the article and pay attention to later paragraphs which discuss liquidity provision, price formation, and market stabilization.
- djur 12y ago"Social function" is a term of art in sociology. It is absolutely not meaningless in this context. http://en.wikipedia.org/wiki/Structural_functionalism http://en.wikipedia.org/wiki/Structural_functionalism
- scrumper 12y agoGood article. For lay readers, perhaps you might include a definition of your usage of 'asset manager' (where you reference Blackrock). It's confusing if you don't know the terminology: a hedge fund manages assets sometimes on behalf of institutions, but it's not an institutional asset manager.
- spuiszis 12y agoGood point. Although, I'd argue that more often than not, institutions (pension funds, funds of funds, etc.) are the ones investing in hedge funds rather than individuals. Usually there is a pretty high minimum investment (and needing to know the right people) that you won't be able to meet, unless you are a very high net worth individual. For example (ps this was a pretty big deal last week), CALPERs the largest U.S. pension fund, is leaving the hedge fund space and re-allocating the 10% of assets they allocated to it, to other strategies like Private Equity[1]. [1]http://dealbook.nytimes.com/2014/09/15/nations-biggest-pension-fund-to-end-hedge-fund-investments/ http://dealbook.nytimes.com/2014/09/15/nations-biggest-pensi...
- auntienomen 12y ago1% not 10%. CALPERS only allocated about $4B out of $300B to hedge funds.
- spuiszis 12y agoThank you for catching that.
- Sniperfish 12y agoThe common definition of a hedge fund I encounter is they're designed to earn an absolute rate of return regardless of how the border markets are performing. There are so many strategies (even down to use of derivatives, leverage, shorts, etc) employed by HF managers to achieve this that defining the HF industry by strategy doesn't seem viable.
- mk00 12y agoThis article claims hedge funds aren't allowed to advertise to the public. That is not true anymore. http://dealbook.nytimes.com/2014/02/20/with-ban-on-ads-lifted-hedge-funds-test-waters/?_php=true&_type=blogs&_r=0 http://dealbook.nytimes.com/2014/02/20/with-ban-on-ads-lifte...
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- AngrySkillzz 12y ago... He mentioned that in the article?
- ISL 12y agoSee the article, paragraph 37 (or Control + F for "LTCM").
- epx 12y agoNot everything needs to have a social function.
- eggoa 12y agoTrue, but it's nice to have one when the social costs are evident.
- kohanz 12y agoExactly. Their function is creating market-beating returns for their investors. Nothing else. There was a great interview with Josh Reich from Simple on Mixergy recently [0]. Before Simple, he worked at a hedge fund but didn't find the work to be fulfilling because he didn't feel that he was solving a problem for anyone, or making people's lives better (he had studied to be a doctor prior to that as well). He summed it up by jokingly saying "I've never had someone come up to me on the street, saying 'I need liquidity!!'". [0] http://mixergy.com/interviews/joshua-reich-simple-interview/ http://mixergy.com/interviews/joshua-reich-simple-interview/ edit: wow, there is some hedge-fund sympathizer down-voting every post that doesn't buy into this "social function" premise.
- 87ctyf93w67tcj 12y agoHence the tragedy of the commons.
- rbcgerard 12y agoI wonder if the people talking about "social function" have applied this standard to candy crush and angry birds?
- kohanz 12y ago...their trades are supposed to bully mis-priced assets into more reasonable valuations. That way, undervalued securities pick up in price, and overpriced securities are shorted down before they form a bubble. Though hedge funds failed to prevent the last two bubbles, it was not for lack of trying: Hedge funds bet against many tech companies, and many were on the right side of the housing bubble, i.e. holding CDS on the CDOs. So, in essence, hedge funds either failed or are incapable of actually fulfilling one of their main social functions (to avoid "bubbles" by helping to achieve more "reasonable valuations"), but "hey, some of us tried!".
- idlewords 12y agoTheir social function is to hasten the glorious Revolution.
- bedhead 12y agoDisclaimer: I am a hedge fund manager. Here's the definition of a hedge fund: an investment firm with extremely high fees whose investment strategy probably falls outside the scope of the vast majority of accessible investment funds. Most criticisms of hedge funds are so weak that they border on straw man arguments. There are fair criticisms for sure, but mostly those complaints are centered around the fees being too high. Asking about their "social function" is a leading question and shows that the author isn't looking at this very objectively.
- bjelkeman-again 12y agoSaying that objectivity I missing from someone that wonders about a social function in an economic vehicle, is IMO a straw man argument. It isn't like the current capitalist economic model is the only true and objectively correct path for society.
- jackgavigan 12y agoIf you're interested in reading some more about the collapse of LTCM, I recommend When Genius Failed by Roger Lowenstein (for a fuller appreciation, read Liar's Poker by Michael Lewis first). If you're interested in reading an excellent account of a startup HFT/hedge fund, it's worth ordering a secondhand copy of The Predictors by Thomas Bass (for a fuller appreciation, read Chaos by James Gleick first).
- tptacek 12y ago_When Genius Failed_ is a freaking fantastic book; even after the 2008 crisis, still one of the all-time best pieces of financial narrative journalism ever. I'm not sure _Liar's Poker_ sets it up that well. Go ahead and read Lowenstein first. In fact, it might even work better the other way around, because Lewis' narrative is really fragmented and Lowenstein's isn't.
- scott_s 12y agoAgreed on "Liar's Poker". I read it after "The Big Short", and I was surprised at how disjointed it was. It was Lewis' first book after leaving finance, and it showed. But I just added "When Genius Failed" to my wish list, based on your all's recommendation.
- jackgavigan 12y agoLiar's Poker includes an anecdote about how John Gutfreund (CEO of Salomon Bros) challenged a bond trader called John Meriwether to a high-stakes game of Liar's Poker: "One hand. One Millions dollars. No tears." John Meriwether went on to found LTCM. Liar's Poker provides some of the background and context for the story Lowenstein tells in When Genius Failed.
- tptacek 12y agoSure, I know that, but my point is that the LTCM story is actually easier to follow than Liar's Poker, and knowing who the characters are coming in to LP makes it easier to follow. There's really nothing in Lewis' book that explains anything about LTCM, but there's stuff in WGF that shines a light on some minor characters in LP. Read When Genius Failed first.
- lmg643 12y agoWhat social functions do hedge funds provide, indeed? Renaissance Technologies avoided $6bn in taxes by using derivatives to pretend their ultra-high frequency trading profits were actually long-term capital gains. http://www.bloomberg.com/news/2014-07-21/renaissance-avoided-more-than-6-billion-tax-report-says.html http://www.bloomberg.com/news/2014-07-21/renaissance-avoided... Renaissance is one of the biggest and most successful hedge funds of all time. SAC was another of the most successful hedge funds of all time - government couldn't get anyone to prove insider trading directly implicating the founder, but they got enough people around him to confess that they've basically cut the fund down to a personal funds only shop - Point72. What else ... Plenty of socially questionable legal strategies in HF land. Big one is stock buybacks - rational responses to Federal Reserve interest policies. If debt is priced too cheaply, HF will push companies to lever up to buyback stock. This is a socially useless form of activity, which increases business risk based on capital structure theory. Short term payoff, the debt will never go away. Returns - the Hedge Fund industry in aggregate is so far off the S&P500 over the past 5 years that perhaps it ought not to exist? http://www.bloomberg.com/news/2014-09-17/hedge-fund-performance-eases-calpers-divesting-chart-of-the-day.html http://www.bloomberg.com/news/2014-09-17/hedge-fund-performa... So - to deliver middling average returns, the hedge fund industry will charge 4x to 20x the cost of an index fund. Much of the money for the funds comes from public pension funds. We can go on...
- damoncali 12y agoA hedge fund is a fee structure, not an asset class.
- deleted 12y ago[deleted]
- soupboy 12y ago> How did a few asset managers earn more money in a single year than Pierpont Morgan did in his whole life? Ummm, no they don't. $1 in 1913 is around $24 in today's dollars[http://data.bls.gov/cgi-bin/cpicalc.pl?cost1=1&year1=1913&year2=2014 http://data.bls.gov/cgi-bin/cpicalc.pl?cost1=1&year1=1913&ye...]. So JPM's net worth today would be $36 billion making him the 12th richest person person in the world [http://www.bloomberg.com/billionaires/2014-09-19/aaa http://www.bloomberg.com/billionaires/2014-09-19/aaa].
- guelo 12y agoCalPERS, the largest pension fund, is pulling out of hedge funds entirely due to weak returns and high fees. http://www.forbes.com/sites/jonhartley/2014/09/22/why-calpers-is-exiting-the-hedge-fund-space/ http://www.forbes.com/sites/jonhartley/2014/09/22/why-calper... What pisses me off the most about hedge funds is that they are a powerful center of political corruption, as evidenced by the inability of Washington to close the disgusting "carried interest" tax loophole.
- sseveran 12y agoCalPERS has too much money to effectively invest in hedgefunds. Good article here: http://www.bloombergview.com/articles/2014-09-16/calpers-has-lost-interest-in-hedge-funds http://www.bloombergview.com/articles/2014-09-16/calpers-has... Hedge funds are not the only people that benefit from carried interest. Real estate and energy investments benefit from it as well. Those industries have far more pull than hedge funds ever will.
- damoncali 12y agoIf you untangle the carried interest taxes, it gets more complicated than that. To close that "loophole" is basically to get rid of sweat equity. When you put it that way, it doesn't sound quite as appealing. I'm not saying it's not a debatable issue, but it has nothing to do with corrupt hedge fund managers.
- KMag 12y agoMost popular press analysis of hedge funds that I've seen lumps them all together and assumes they're all primarily aiming to provide greater expected total returns than any of the major equity indexes. However, judged by this metric, the S&P 400 midcap index has historically outperformed the S&P 500 index, which has in turn historically had higher total returns than a balanced portfolio of index funds and bonds. Be careful about any analysis that when applied to these investment options would conclude that someone in their 50s should hold all of their money in an S&P 400 index fund instead of having a better diversified portfolio. Many hedge funds aim to have better risk-adjusted returns by some metric (say, Sortino ratio or Sharpe ratio) than the major stock indexes or other asset class benchmarks, or the traditional advice of a balanced portfolio of equity index funds and bonds. They often consciously sacrifice some expected returns in exchange for reduced downside volatility. Some hedge funds try to provide as good returns as possible while having as low correlation as possible to the major asset classes available outside the fund (equities, bonds, commodities, real estate, etc.). These sorts of funds expect their investors to have major holdings in equities, bonds, commodities, real estate, etc. outside the fund. These sorts of funds view themselves as an extra option for diversification for individuals who are already well diversified in the major asset classes. Some funds (mostly short-only funds) aim to be anti-correlated to some asset class (typically equities) as cheaply as possible, so that holdings in the asset class combined with holdings in the fund result in better risk-adjusted returns (say, Sortino ratio or Sharpe ratio) than just holding major index funds along with some out-of-the-money long-dated puts on those indexes. Many of these sorts of funds expect to have several years of small losses, punctuated by large gains in years when their investors' other holdings have major losses. In short, I'm sure there are plenty of just plain poor funds out there. However, depending on the investor's utility function and holdings outside of the hedge fund, it may be rational for the investor to have holdings in a hedge fund even if that fund consistently under-performs the S&P 500 and MSCI World Index.
- goodside 12y agoThis really damages the credibility of the article: "These investors must prove a certain net worth and go through a restrictive application process to become accredited." In fact, there is no application process whatsoever. No organization "accredits" an accredited investor, and the SEC doesn't keep a list of who is and who isn't. If you satisfy the SEC definition, you simply are one: http://www.sec.gov/answers/accred.htm http://www.sec.gov/answers/accred.htm Your status as an accredited investor is self-certified. If you go to a hedge fund with a sack of money and claim to be accredited, they'll take your word for it. All that the law requires is that they have a "reasonable belief" you're telling the truth. From SEC Release 33-6455: "What constitutes 'reasonable belief' will depend on the facts of each particular case. For this reason, the staff generally will not be in a position to express views or otherwise endorse any one method for ascertaining whether an investor is accredited."
- prostoalex 12y agoThe requirement protects their liability if later on you decide to sue them for losses.
- dharma1 12y agorandom thoughts -much of the finance industry is self serving -as competition grows and/or returns are consistently lower than index funds, the 2/20 fees should come down. if not, then something is not working properly