American Enterprise Institute – Hedge funds have just been “discovered.†Ordinary investors are clamoring to participate in rewards once the province of the very rich. Reporters are probing to exposewhat has been a closed culture of secrecy. Policymakers are asking the usual questions about risks to the unsophisticated investor and to the stability of the global financial system.
For those who live and work in the marketplace, hedge funds are no mystery. They are simply pools of money seeking the highest absolute rate of return across the capital markets with a management compensation structure that commands a high share of profits. They have been here for more than a generation and, like any financial innovation, are following a normal life cycle. First, a small number of pioneers garner excess profits; next, competition and capital are broadly attracted; finally, the concept moves into the mainstream, matures, and is winnowed out until the risk/reward ratio approaches that of other instruments. Even as profits narrow, hedge fund returns that are uncorrelated with general market trends will secure the industry a permanent place in the investment roster.
When floating exchange rates and volatile interest rate movements transformed the capital markets in the late 1970s, hedge funds entered quietly with an irresistible formula for investment: make money whether the market rises or falls. These were small groups of innovative traders, some inside large investment banks funded by the bank’s own capital, others in independent firms financed by less than 100 rich individuals prepared to commit millions to a new technology.
Managers searched for anomalies as investment opportunities–momentary misalignments in the pricing of securities, currencies, and commodities around the world. They matched holdings with short sales to isolate generalized market risk. They borrowed heavily to leverage positions and magnify returns. Rewards were overwhelming and consistent at 40 percent per annum. Because the new technology was partnered with a new compensation structure geared to performance, managers became the most highly paid people in the market. They received 20 percent of profits. As investors and managers plowed back their gains, small funds quickly grew into multibillion dollar forces.
