
What are hedge funds, and what social functions do they serve? - jimiwen
http://danwang.co/what-are-hedge-funds-and-what-social-functions-do-they-serve/
======
lmg643
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.

[http://www.bloomberg.com/news/2014-07-21/renaissance-
avoided...](http://www.bloomberg.com/news/2014-07-21/renaissance-avoided-more-
than-6-billion-tax-report-says.html)

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...](http://www.bloomberg.com/news/2014-09-17/hedge-fund-performance-
eases-calpers-divesting-chart-of-the-day.html)

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...

~~~
m52go
You're conflating 'social' with 'moral'. Everything you mentioned is morally
questionable, not socially harmful.

~~~
atmosx
Geez we all enjoy the benefits of the 2008 financial crisis. Society was never
happier.

~~~
m52go
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.

~~~
atmosx
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!

[1]
[http://online.wsj.com/articles/SB123734123180365061](http://online.wsj.com/articles/SB123734123180365061)

[2]
[http://en.wikipedia.org/wiki/American_International_Group#Li...](http://en.wikipedia.org/wiki/American_International_Group#Liquidity_crisis_and_government_bailout)

~~~
m52go
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.

------
danwyd
Fairy 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
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.

~~~
bradleyjg
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.

------
goodside
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](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
The requirement protects their liability if later on you decide to sue them
for losses.

------
jackgavigan
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).

~~~
tptacek
_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.

~~~
jackgavigan
_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_.

~~~
tptacek
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.

Read When Genius Failed first.

~~~
jackgavigan
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.

~~~
tptacek
You have me curious now. What's some of the background and context from Liar's
Poker that's valuable for reading When Genius Failed?

------
bedhead
Disclaimer: 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
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.

------
KMag
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.

------
mk00
This 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-
lifte...](http://dealbook.nytimes.com/2014/02/20/with-ban-on-ads-lifted-hedge-
funds-test-waters/?_php=true&_type=blogs&_r=0)

------
epx
Not everything needs to have a social function.

~~~
eggoa
True, but it's nice to have one when the social costs are evident.

~~~
m52go
What's the social cost of hedge funds?

------
guelo
CalPERS, 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-
calper...](http://www.forbes.com/sites/jonhartley/2014/09/22/why-calpers-is-
exiting-the-hedge-fund-space/)

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
CalPERS has too much money to effectively invest in hedgefunds. Good article
here: [http://www.bloombergview.com/articles/2014-09-16/calpers-
has...](http://www.bloombergview.com/articles/2014-09-16/calpers-has-lost-
interest-in-hedge-funds)

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.

------
scrumper
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.

~~~
spuiszis
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].

[1][http://dealbook.nytimes.com/2014/09/15/nations-biggest-
pensi...](http://dealbook.nytimes.com/2014/09/15/nations-biggest-pension-fund-
to-end-hedge-fund-investments/)

~~~
auntienomen
1% not 10%. CALPERS only allocated about $4B out of $300B to hedge funds.

~~~
spuiszis
Thank you for catching that.

------
ihsw
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.

------
_random_
What is the social function of Google's tax evasion?

------
Sniperfish
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.

------
dharma1
random 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

------
damoncali
A hedge fund is a fee structure, not an asset class.

~~~
guelo
That was mentioned in the article.

~~~
damoncali
I was being a smart ass. My point was that there is no definition - they're
just money managers who charge a lot and do whatever they want.

------
idlewords
Their social function is to hasten the glorious Revolution.

------
soupboy
> 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&ye...](http://data.bls.gov/cgi-
bin/cpicalc.pl?cost1=1&year1=1913&year2=2014)]. 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)].

~~~
bza
The $1.5 billion figure given in the article is already in today's dollars.

~~~
damoncali
JP Morgan was far richer than that in his day. It's disingenuous at best.

------
kohanz
_...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!".

------
basseq
Notes 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.

~~~
Sniperfish
Speculation 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
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

~~~
auntienomen
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.

