What 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.
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?
There was no dishonest or misleading tactic that Renaissance tech used. They held on to options and used that legal tax structure. Options for a basket of stocks and the basket of stocks themselves are completely different things and have different risks and payouts. That they are using derivatives to avoid taxes is just drama that politicians are inventing.
"The facts indicate that the basket option structures examined in this investigation were devised by sophisticated financial firms to allow clients to circumvent federal taxes and leverage limits. The structures rested on two fictions. The first was that the bank, rather than the hedge fund, owned the assets being traded in the designated option accounts, even though the hedge fund bought and sold the assets, was exposed to all significant risks and rewards, and profited from the trading, with little input from the bank serving as the nominal owner of the assets. In
effect, the structure purported to enable the hedge fund to purchase an “option” on its own trading activity, an arrangement that makes no economic sense outside of an effort to bypass federal taxes and leverage limits. The second fiction was that the profits from the trades controlled by the hedge fund could be treated as long-term capital gains, even for trades lasting seconds. That fiction depended upon the hedge fund claiming that the profits came from exercising the “option” rather than from executing the underlying trades. In fact, the “option” functioned as little more than a fictional derivative, permitting the hedge fund to cast short-term capital gains as long-term gains and authorizing financing at levels otherwise legally barred for a customer’s U.S. brokerage account."
So the complaint is that this was fictional derivatives used to mask ownership of the underlying assets and thereby avoid taxes. I'm going to do some more research but it does sound shady.
Earlier, the complaint points out that the IRS has already identified this as abusive behavior but has not acted:
"While that type of option product was identified as abusive in a public memorandum by the Internal Revenue Service
(IRS) in 2010, taxes have yet to be collected on many of the basket option transactions and its use to circumvent federal leverage limits has yet to be analyzed or halted."
Renaissance did not avoid $6b in taxes. They never owned the stock in the baskets that the politicians claimed they did. The payout to risk ratio of the options is most likely why they were invested. There can't be a social function to not paying because there was nothing to pay.
I don't know specifically about Renaissance's case, but they may well have avoided $6B in taxes if a lot of their fees were categorized as "carried interest". (I don't think the particular fact that they invest in derivatives has anything to do with it.) For hedge funds any fees they accrue for "performance" are carried interest and not subject to regular income tax, though they will eventually be taxed at the capital gains rate. E.g., if a hedge fund charges 2% of assets annually, plus 20% of annual increases in asset value over 8%, the 2% fee would be taxed as regular income and the performance part (20% of increases > 8%) would accrue to them as carried interest, treated as capital gains.
My not-so-informed belief is that while there may originally have been a decent rationale for treating hedge fund performance fees as carried interest, in many (most?) modern hedge fund scenarios that categorization is misapplied. In any case, the treatment as carried interest is legal, at least for now.
Those taxes are not avoided - it's just the current tax law. Money put at risk is taxed as capital gains. You don't automatically get carried interest - if you don't perform, it's zero.
Think of it as a portion of their salary that they are contractually bound to invest in the fund, with deference to the limited partners.
Do we really want to have fund managers without skin in their own funds? Carried interest is the only way to do that that does not favor the fantastically rich - who have enough advantages already. Ask yourself what might happen to the private fund industry (VC, PE, hedge funds, real estate, etc) if managers were not able to get carry. How would their compensation change? Which funds would benefit? Do we really want that?
It's not an issue of whether someone should get carried interest - it's an issue of the rate at which that carried interest is taxed.
Funds are essentially providing a service for a given investor but getting taxed as though it was all their own money in the fund - which is not the case in most funds.
Instead, what the funds are doing is essentially providing investment advice - for which the fees should be taxed at normal rates rather than at the carried rate as though it is all their own money.
So I have no issue with the manager getting carried interest or being taxed at lower rates on their own money - but when they take money from outside investors, they should be taxed at normal rates.
I won't argue that our tax code is anything but ridiculous. But treating carried interest and capital gains the same way makes sense - it's money put at risk as an investment. I don't think it's relevant that in one case cash is risked and in another case it's compensation at risk. Nobody is goign to argue that the management fee is capital gains because it isn't - it's guaranteed cash. It's different.
I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me.
"I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me."
Looks more like income to me - fees paid to people for managing money that they themselves have not put at risk.
Again, we're not talking about getting carried interest - we're talking about the taxes on that carried interest. They put the capital at risk, but this is no different than any fee-based service, thus it is income rather long term capital gains.
If they took part of their salary and opted (or were required by LP's) to invest that money in their fund, should any gains there be taxed as capital gains or ordinary income? They would clearly be capital gains.
What is the difference between that and carried interest? The only thing I can think of is that it's not taxed as ordinary income before being invested, which is a fair criticism. On the other hand, you don't get a tax benefit if you lose that money in the CI case (which happens a lot), so it balances out at least to a degree.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
> Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit.
There's a pretty good argument that some special treatment of income from long-term holdings (or, at least, something that accounts for them) is necessary in a system with progressive taxes on annual income, because otherwise small investors with infrequent realizations of income from long-term holdings would be taxed more on their income (on average) than people with the same average annual income who made constant income year-to-year.
OTOH, one can argue that the particular mechanism of long-term capital gains is a bad mechanism for that because it doesn't account for similarly irregular non-capital income (e.g., a writer whose income is mainly royalties that are concentrated immediately after new book releases who infrequently releases books that are bestsellers, but with several years of minimal income in between) and, at the same time, undertaxes capitalists that can afford enough in long-term holdings that rotate to realize constantly high income from long-term holdings.
Things like hedge funds and carried interest are sort of nibbling around the edges.
I'd have no issue with their own investments in the fund being taxed as long term capital provided they have held the investment for a year when the profit is taken.
Here's a simple way to think about it - an ordinary RIA invests money on behalf of their clients. The fees they get for that service are taxed as ordinary income. Why should carried interest be any different when the money is coming from clients? And why should carried interest be taxed at a lower rate regardless of hold time? The simple answer is that these fees aren't any different - and therefore should be taxed at the same rate in my opinion.
Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income.
To take it a step further, should entrepreneurs pay ordinary income tax on their gains when they sell their company if they didn't invest any of their own money? It's the same thing. Carried interest is just a fancy name for sweat equity.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
Comparing selling your company to carried interest isn't appropriate - apples and oranges - but to your entrepreneurs example: if they accept investment in their company, then their company has shares. Gains on those shares are treated exactly the same as any other share in any company - short term gains on stock held less than a year or long term if you've held it a year or longer. This is why many people exercise their options in a startup as a way to start that clock as soon as possible to avoid short-term tax consequences.
Again - PE firms are offering a service and will receive a good profit for their hard work. But that work often involves minimal capital on their part and therefore should not be treated as if it is their capital at risk.
"Money put at risk is taxed as capital gains." Huh? Money that hedge fund owners provide as fund capital is already theirs, they don't pay tax on it at all. Of course gains in value of their capital investment are taxed as capital gains. But the performance fees we're talking about are fees that accrue to hedge fund managers from managing _other people's money_, not the capital gains that manager's realize directly as the increase in value of their own investment.
If hedge fund managers could not performance fees categorized as carried interest they'd pay regular income tax rates on them. Not sure how that changes their management of the funds. Presumably if they believe they're the best managers out there they'll want to have their own assets in their fund (and of course will pay only capital gains tax on increases in value of their assets). By the way, high percentage of hedge fund managers are already among the "fantastically rich". . . .
> 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.
If it's useless then why does it make them money? Capitalism is a bit like a genetic algorithm - it will find a badly specified reward function faster than it will find the solution you were looking for - but if our tax policies encourage businesses to take on dangerous levels of debt, maybe we should, like, change our tax policies?
> So - to deliver middling average returns, the hedge fund industry will charge 4x to 20x the cost of an index fund.
Shouldn't we be happy about that? They take a load of rich people's money, provide liquidity to the market and do other price discovery things, and give those rich people a middling average return. What's not to like?
> Much of the money for the funds comes from public pension funds.
Maybe those pension funds should stop investing in hedge funds, like calpers just did.
> If it's useless then why does it make them money?
Is that really a line of reasoning? I can make money by drug and arms trafficking, helping other skirt the law, take advantage of legal loopholes, using violence where competitors cannot to strongarm others into submission, exploiting labor, etc.
If a hedge fund makes its money just by being faster in transactions in a way that gives no real benefit to actual creators of value, then it is of no use to society.
Thus far, the argument for liquidity seems shoddy, at best.
Hedge funds are opportunistic pools of capital. Like venture capital firms, they exist primarily to make a buck, only hedge funds play primarily in the financial markets.
Real estate firms exist to make money using real estate. Banks exist to make money using loans.
Finance exists to make money. By design, it doesn't care about real value.
> Is that really a line of reasoning? I can make money by drug and arms trafficking, helping other skirt the law, take advantage of legal loopholes, using violence where competitors cannot to strongarm others into submission, exploiting labor, etc.
By and large you can't, which is the point. We don't stop these things by appealing to people's better natures. We stop these things by making them unprofitable. When hedge funds misbehave it's usually a symptom, not a cause.
It's not the hedge funds that are paying dividends/repurchasing shares - it's the companies they invest in. The companies create value and pass the profits on to their investors. This has nothing to do with trading.
Because they also flease institional investors. While not talked about there are huge incentives for here funds to bribe money managers at pension funds etc. A hede fund managing 100 million that lost 50% of the money over 10 years makes well over 10 million, break even and there up 20 million.
The claim is that corporations will borrow money and use it to buy back shares. That's actually a nice hack - interest income is favorably treated relative to capital gains, so it's a way to turn a higher tax piece of capital (stock) into a lower tax piece of capital (bonds).
If it's advantageous to have more debt, then this is what you do. It's done by pretty much every company in the world, not just hedge funds. It's literally finance 101.
My understanding is that phones4u was paying out dividends while increasing its debt; effectively an equity-for-debt swap. The difference is that this transfers risk from the owners to the creditors, allowing the business to collapse after it's been looted.
I think there's a case to be made for a rule "always pay your creditors before your equity investors" to avoid this kind of thing.
That's how it's supposed to work. A company makes money and gives it to the shareholders. When lenders lend money to the company, they are getting a return for their risk. Companies adjust their capitalization all the time - it's a normal part of running a business. You can do it with dividends or share repurchases, and if it makes sense, you can fund either with debt. There is nothing nefarious about doing that.
Further, if you always pay your creditors first, there is no point in capitalizing with debt - you give up significant value by doing so. It is normal and healthy for some companies to finance themselves perpetually with debt.
Edit: Ok, so there are still some non-believers. Think of it this way. You own a profitable company with no debt. Your accountant tells you that you'll increase the company's value if you are 50% debt and 50% equity. This is a consequence of our tax code. Sounds like a good plan. Now what? The company already pays dividends and has as much cash as it needs for operations. You borrow money (which banks are happy to give you because you can more than afford the debt service), and pay out the proceeds as dividends. You are now have all that money in your pocket, and your company is basically worth the same amount (value = equity, which is now 1/2 what it was + debt) - a little more, actually, because of the tax consequences of the debt.
This is totally normal. Sometimes the optimal debt level is zero. Sometimes it's 90%. If companies are pulling huge amounts of cash out as a result of debt financing, it's only because they had a sub-optimal capitalization to begin with. Again - nothing nefarious here. It's all just a way of adjusting risk and optimizing returns to the shareholders.
The social function of hedge funds is to provide the expected returns for their given investor (examples: uncorrelated returns to the S&P500, downside protection, returns generated by non-stock/bond investments, et al) - the same as any investment vehicle. Those returns should then be accrued to the investors in a given fund, thereby enabling things like pensions as well as non-retirement gains.
Now, I don't believe this is what they provide, but I'm trying to answer your question.
> 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.
Aren't stock repurchases generally a more tax-efficient vehicle for providing return to shareholders than dividends?
Also, why would the debt never go away? Companies usually raise debt by selling bonds with maturity dates.
Most moral wrongs are also social wrongs. Laws and regulations exist for the good of society, and flouting those laws is bad for the public good. If you pay less in taxes than you ought to, that means that the average citizen either pays more in taxes or doesn't get the social services those taxes would have paid for. Insider trading means that the insiders profit at the expense of the outsiders, who are typically far more numerous.
> If you pay less in taxes than you ought to, that means that the average citizen either pays more in taxes or doesn't get the social services those taxes would have paid for.
No, it means SOMEONE is paying more. That someone could be a rich person, another company, or a smorgasbord of other taxpayers. You can't assume it's Joe the Plumber who's paying more taxes (on average, because proportionally, corporations and rich people pay most taxes).
Also, don't assume those taxes would have paid for social services. They could have also been used to kill innocent women and children in unspeakably nasty ways (on average, most of the budget does NOT actually go to social services).
The vast majority of trading is done by institutions, so here again, your assumption that Joe the Plumber gets hurt by the big bad hedge funds doing insider trading is faulty. Yes, 401(k)s might get hit, but it's not your average E*TRADE daytrader who's losing out (again, on average, based on trading volume).
Anyway, in the name of morality, it's irrelevant to speculate WHO pays for your wrongdoing and for WHAT your taxes would have been used.
The action is immoral and illegal. To say it's socially wrong is a big stretch. There are way too many unknowns to make a definitive statement.
That was almost entirely caused by an institution known as the BANK.
Banks and hedge funds are totally different things. Likening one to the other is like saying Google and Square are both evil just because they're technology companies.
You seem to lack a fundamental understanding of the financial system.
Oh really? So in your dictionary AIG is a bank, like say BoA. You seem like having a deep understanding of the financial system. Don't forget to edit the wikipedia page, these guys got it all wrong[2] oh yes the WSJ[1] too!
There were many types of institutions involved in the 2008 crash, from traditional banks to investment banks to ratings agencies to insurance firms to mortgage brokers to governmental bodies and more.
The root cause of the crash was unquestionably the banks. It was the banks that lowered their standards, made bad loans, and packaged them up into MBSs and CLOs to ship them off to other institutions to trade and insure so they could make more bad loans.
If the banks didn't make these loans, AIG would have had nothing to insure. Goldman would have nothing to trade. S&P would have nothing to rate. Et cetera.
Don't misconstrue what I'm saying as vindicating everyone else. They all royally messed up too. It's just that the banks started and perpetuated it all.
The 2008 financial crisis was not brought on by people avoiding taxes. I don't think any crisis can be caused this way because the US government can easily borrow money when it needs and clamp down on tax avoidance or raise taxes later.
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.
Long-Term Capital Management's bailout was organized by the Fed even though it didn't actually take on the assets. If the private bailout hadn't been agreed to, then the Fed would have directly intervened.
I say this to correct the record, not to detract from your point about risk management, which is true.
And it is not whether an organsiation is a bank or a hedge fund that determines if it is bailed out - it is the expected social cost of it's collapse that determines it - hence LTCM was bailed out, because the smart money thought it would take us all with it and why Lehmens was not (mistakenly?)
I think the issue at the time was that none of the big banks/financial entities trusted each other anymore. Everything was grinding to a halt and one by one companies were collapsing and having to be bailed out by the US government. I think a point was reached where it was decided to let Lehman fail, stress test the system in order to see who was really solvent and who wasn't and then prop it backup and reinflate it.
Oh I got the impression it was more a philosophical idea "moral hazard" was allowed to proceed, then it scared everyone. I seem to recall the Governor of the. Bank of England saying Lehman was an example of avoiding the moral hazard of bailouts then 24 hours later bailing out started.
There is a good podcast on LSE / iTunes with Adair Turner and Buttonwood Writer from The Economist who are the fire I have heard to beyond "Banks and fraud and regulation" and into "Global savings, infinite credit" and suggest things like 100% reserve banking (ie no credit if not created by central banks)
It's worth listening too even if it's rather uneven.
Oh there was an element of that in there as well. But bear in mind before Lehman they'd bailed out AIG I believe to the tune of 200billion USD? I think to keep effectively writing blank cheques to cover Wall Street's fuckups was becoming increasingly untenable. I think they were faced with three choices, keep bailing out publicly which was politically untenable, bailout on the quiet which would likely have ended up with Japanese style Zombie corporations or let Lehman fail and get the worst over with.
If 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.
We 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.
1. 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.
This 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
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."
If 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).
_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.
Agreed 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.
Liar'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.
Sure, 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.
I'm not talking about just the characters. I'm talking about background and context.
You clearly disagree, which you're perfectly entitled to do.
For everyone else: I've worked in the financial markets for over a decade, I'm an ex-trader who used to deal with hedge funds like (and including) George Soros's Quantum Fund. My advice is to read Liar's Poker first.
This one is also great - mostly because it was written right before the collapse, and it nails everything (at least as far as causes go - his solutions are debatable). Very smart book.
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.
Saying 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.
Most 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.
Exactly. 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!!'".
Surely those app/games have an obvious social function, entertainment. That is the vehicle through which these Skinner-box like tools are accepted enabling them in a minority of cases to extract relatively large amounts of cash via, eg, IAP.
I, like millions upon millions of others, played both and found them entertaining. They don't appear to return value commensurate with their incomes and have certain strong negative influences on a limited number of players.
The function of hedge funds is to extract worth from the financial markets by riding natural, or forced, fluctuations in the price of securities and other instruments.
It's financial trickery that enables extraction of value without valuable input. There's always some arm-wavey stuff about how they add valuable liquidity but TBH that always seems bogus to the extent that the liquidity gained isn't worth anywhere near the value extracted. As they're meta-trades they may have a damping effect but it seems if an acceleration can be achieved, using lots of leverage, then more gains are created. Encouraging market instability appears to be the way to create greater opportunities for profit - but I'm a layman, perhaps I'm seeing it wrong?
As far as social function it seems that is to hedge the investments of the rich [which term I recognise is subjective] with returns which don't necessarily fall with traditional markets.
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.
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.
If 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.
Good 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.
Good 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].
Thank 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.
The 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.
-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
...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!".
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.
Yeah, 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.
Note 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
Moreover, 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.
You 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.
> 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.
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...
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-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...