Hedge Funds 101

There are about 7,000 hedge funds in the world. While hedge funds were conceived in 1949, the industry started to get noticed in the 1960s, fewer than a thousand of them existed worldwide prior to 1990, and they have grown dramatically every year since then. Hedge fund managers are among the wealthiest people in the world, some making billions of dollars a year, and in particular, are among the wealthiest individuals within the financial community which itself has taken the lion's share of the economic gains of the current boom. Hedge funds have also attracted notice because they tend to engage in heavy trading that influences the day to day pricing of the financial markets.

Hedge funds currently have about $2,000 billion under management (before the late 2008 crash), a 50 fold increase since 1990. Most are fairly small, however. "Firms with less than $500m under management account for about three-quarters of the world’s 7,000-odd hedge funds, although they manage less than a tenth of the industry’s assets." The average hedge fund with less than $500 million in assets manages about $38 million. The average hedge fund with more than $500 million in assets manages about $1 billion in assets.

By comparison, at the end of September, 2008, the total capitalization of the U.S. stock market, based upon current stock prices, was about $12,500 billion. The market capitalization of publicly held companies outside the U.S. is at least as great as the market capitalization of the U.S. market. So, worldwide, the total hedge fund market is less than 10% of all equity investments (and of course, the aggregate capitalization of the world bond markets is also huge).

The funds are only modestly regulated because they deal only with sophisticated investors. About 32% of investments are from high net worth individuals, 5% from endowments, 6% from institutions, 10% from pension funds and 46% from funds of hedge funds which "act as intermediaries for private banks, some institutions and individuals who are merely affluent," as opposed to the very wealthy.

Typically hedge funds allow investors to take out money only quarterly, a small number allow monthly withdrawals, and a few allow withdrawals only every few years. They typically have performance related fees, and may not receive any of those until they restore the peak value they achieved before a slump in value. They also have "a symbiotic relationship with prime brokers at investment banks, who provide them with credit, execute trades and help administer their funds." Industry boosters fear that client withdrawals and denials of credit from investment banks could greatly contract the industry.

Surprisingly, most hedge funds are not terribly leveraged (although this differs from one type of strategy to another). For the industry as a whole, asset to equity ratios of 1.3 to 3 are estimated, far less than either commercial banks or investment banks, and more in line with operating companies, although this conceals leverage in the underlying investments, many of which are derivatives. Unsurprisingly, given the leverage information, investment banks has done more to drag down hedge funds than hedge funds have done to drag down investment banks.

Hedge funds have sold themselves on the suggestion that they can produce steady returns in good times and bad, but have actually managed only to outperform the market in bad times. The hedge fund description conceals a variety of different investment strategies, some of which have worked as advertised, while others, like exploiting anomalies between convertible bond prices and stock prices, have produced losses as severe as those in the ordinary stock market.

Recent increases in regulation of short selling have hurt the funds, which often simultaneously put and short the same investment (the classic definition of a hedge) to limit both upside and downside risk. Take away the option to short sell in a particular situation, and you don't have a hedge any more.