Hedge Funds Ate My Money: Facts and Fantasies in Alternative Investments
"Take a speculative cocktail shaker. Add four parts public ignorance and 33 parts greed. Toss in a little perceived genius. If you don’t have any freshly ground perceived genius to hand, a little dried genius status will do. Season generously with mystique. Add apparent publicity shyness to taste. Serve in opaque tumbler of awed, ill-informed media coverage." Martin Baker 
Hedge funds are "in." St. James and Mayfair in London, the Helmsley building in New York and Stanford, Connecticut are home to a plenitude of hedge funds. "Plenitude" refers to too much of anything. The fund’s names inevitably include the term capital—remember Long-Term Capital Management (LTCM)?
Extreme sports are specialized sports in which participants push themselves to the limits of their physical ability and fear. Hedge funds are "extreme" money. They play adrenaline-rush, high-risk money games with potentially high returns. In his book The Bonfire of the Vanities, Tom Wolfe’s hedge fund manager "[...] considered himself as part of the new era and the new breed...a Master of the Universe who was a respecter only of performance." 
These Masters of the Universe, with their culture of risk and extreme money games, exert enormous power and influence in financial markets. But they remain secretive and little understood. This article looks at the facts and fantasies of hedge funds.
Hedge funds are fashionable, and hedge fund managers are the new financial celebrities. Today, there are probably more than 8,000 hedge funds with over $1,500 billion in assets under management (AUM). Hedge funds have been around for 50 years, but they’re not well understood. In a recent interview, a minor Master of the Universe stated that he threw light on "fragmented information" and "opaque" track records. The statement is reminiscent of another in a company prospectus during the South Sea bubble: "A company for carrying on an undertaking of great advantage, but nobody to know what it is."
In reality, these are the key things to know about hedge funds:
- They’re unregulated.
- They can engage in certain strategies denied to traditional investors, primarily short selling and leverage.
- They focus on generating absolute returns rather than trying to beat an index.
Investment in hedge funds is being driven by multiple factors:
- Institutions. Hedge funds are the latest attempts to beat markets and generate alpha (outperformance).
- Individuals. Generate higher returns than those available from traditional assets.
There are a number of issues with hedge funds:
- Returns. Average hedge fund returns when properly adjusted for risk and survivorship bias (many hedge funds don’t survive) are not above those for traditional assets over longer periods. A few hedge funds outperform, but many of those don’t accept new money.
- Risks. Hedge funds increasingly take "new" risks—correlation, liquidity, complexity, and event risk—that are not well understood and captured by systems, understating the real risk and overstating returns.
- Transparency. More than 50% of hedge funds have been in existence for less than 2 years and are small in terms of size (less than 20 people). This increases operational risks and, combined with the lack of transparency, significantly increases risk.
Banks are the real cheerleaders of hedge funds. A large part of their revenue now comes from helping hedge funds raise capital, trading with them and settling their trades, and (most lucrative of all) funding them. Banks increasingly invest ("seed") hedge funds to ensure flow of business. Internally, banks often replicate hedge fund strategies or market them to other traders. This profit comes with risk. In a severe market correction, large losses by hedge funds may lead to large losses by banks funding and trading with them. This is precisely what happened when Long-Term Capital Management collapsed in 1998.
The fundamental business logic of hedge funds is flawed. There is too much money chasing too few opportunities. Louis Bacon (of Moore Capital), when returning capital to investors, commented: "Size matters. It is the bane of the successful money manager." Clever people can make money if there are a few clever people and lots of opportunities. In 2004, one academic argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. History will show that hedge fund returns, other than a few exceptional cases, reflect the confluence of market conditions and good luck that prevailed in the 1990s.
The large amount of capital commanded by hedge funds creates systemic risks. Increasingly, trading is centered on "big" stories—China, India, corporate actions (leveraged buyouts, mergers, bankruptcies). Traders take positions in a wide variety of instruments, all focused on the same event. The tremendous volatility created by relatively minor events points to the explosive buildup of risk concentration. Central bankers are belatedly focusing on these extreme money games.