A decade ago,when the bankruptcy of Lehman Brothers sent the global financial system into a tailspin and triggered what would become known as the Great Recession, a few creative risk takers—against all odds—became billionaires.
In a financial universe that had just come undone, they appeared to be the brightest stars. These men—and they were almost all men—had foreseen the dangers of the toxic financial instruments most people couldn’t understand. They predicted the fall of Lehman. They seemed to be able to make money—massive sums of money—when everyone else was losing it.
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Take, for instance, John Paulson, a merger arbitrageur who became the master of the “big short” on subprime mortgage-backed securities. Paulson earned $15 billion for his eponymous firm in what became known as “the greatest trade ever” by shorting housing before the housing market imploded. Then there was David Einhorn, the brainy founder of Greenlight Capital who correctly predicted that Lehman would fail.
Paulson and Einhorn belong to a secretive, exclusive club known as hedge funds, which count wealthy individuals, university endowments, sovereign wealth funds and public pension funds among the clients who have lusted after a piece of the wealth and are willing to pay exorbitant fees—typically a management fee of 2 percent of the assets and a performance fee of 20 percent of the gains—for the privilege of belonging.
Their riches made hedge funders, many of them math geeks who’d applied their skills to finance, glamorous. They bought Picassos and Matisses and had museum wings named after themselves. Page Six gossiped about their multimillion-dollar divorces. Their firms’ inner workings were the inspiration for the hit Showtime series Billions, which wonders whether the bad guys are the hedge fund billionaires or the government prosecutors. They had their own tribal gatherings, like SALT, a Las Vegas hedge fund confab and brainchild of hedge fund impresario Anthony Scaramucci, the founder of investment firm SkyBridge Capital. SALT brought together thousands of investors and aspiring hedge funders hoping to mingle with the select few. Former heads of state, movie stars and hedge fund honchos could be found hobnobbing at the gaming tables and drinking Manhattans inside poolside cabanas at the Bellagio every May.
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Hedge funds were sexy. But almost as soon as they became widely popular, something seemingly inexplicable happened: They quit making money—at least not as much money as you could make by simply matching market returns. The years of mouthwatering double-digit returns—SAC Capital Advisors had boasted a 30 percent annualized gain even after taking a huge cut for itself—ground to a halt. Between January 2009 and the end of last year, hedge funds returned an average annualized 6.09 percent, according to Hedge Fund Research (HFR), a data provider. That’s less than half that of the S&P 500, which rose 15.82 percent annually during that time. You could put your money in Vanguard’s Total Stock Market Index Fund, pay expenses of 14 basis points and absolutely crush the returns of John Paulson, David Einhorn, Bill Ackman and many other brand-name hedge funders. Even the world’s largest hedge fund, Ray Dalio’s Bridgewater Associates, whose assets are now an astonishing $160 billion, is among the laggards. Through August, Dalio’s flagship funds earned just under 9 percent over the prior decade—about 20 percent below the comparable number for the broader market.
Before the financial crisis, the best hedge fund managers wildly outperformed the market—and this was after hefty fees.
Having made their billions, many hedge funders just walked away. In the last few years, industry stars Richard Perry and Eric Mindich— both Goldman Sachs alums—were among the luminaries who shuttered their funds. Other funds have shrunk in size and clout. John Paulson’s Paulson & Co. fund peaked at $38 billion in 2011 and is down to $8.7 billion. Most of what remains is his own money. This year, Einhorn’s fund lost an incredible 25 percent through August. In just one week in October, three hedge funds—Tourbillon Capital Partners, Highfields Capital Management and Criterion Capital Management—decided to shut their doors, returning billions of dollars to investors.
Before the financial crisis, the best hedge fund managers wildly outperformed the market—and this was after their hefty fees. Then, when hedge funds started underperforming the market in the years following the crash, their founders had a rationale. “We don’t always outperform,” they seemed to say. “We’re hedge funds. Our job is to manage risk, to prevent downside.” But that argument became hard to sustain when underperformance continued year after year and investors got restless—but fees largely stayed the same. Truth is, what was once the most celebrated instrument in the financial world is simply not working. Yet hedge funds, purported to be the most rational of economic actors, still manage $3.2 trillion. What the hell happened to hedge funds—and why do so many investors seem determined to go down with the ship?
In some ways, hedge funds are victims of their own success.
When Fortune journalist Alfred Winslow Jones invented what he called a hedge fund in 1949, its strategy hedged against market reversals by investing in certain stocks, then shorting others. Shorting involves borrowing a stock and selling it, betting the price will decline before you have to return it to its owner and you pocket the difference.
The SEC considered such trades too risky for the average mom-and-pop investor, and limited hedge funds to the wealthiest investors. But these days, just about anybody can short stocks, through mutual funds or even ETFs. If an investor wants a hedge, there are multiple, cheaper ways of accessing it without paying astronomical fees to hedge funds.
Of course, these funds don’t just invest in stocks. Nor are they an asset class in themselves. The running joke is that they are actually a compensation plan, almost a foolproof way for the owners to make money. The 2 and 20 fee structure is coming down slightly under pressure from investors, but some successful managers still charge even more. As a result, even when returns are low or nonexistent, the management fee on billions of dollars can still pay for a hedge fund titan’s Hamptons mansion and Gulfstream jet.
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The prospect of eye-popping paydays led a stampede of finance types to launch their own hedge funds, often after a stint on Wall Street trading floors, but occasionally while still in college—the route taken by Citadel’s Ken Griffin—or after an apprenticeship with an established hedge fund, like Julian Robertson’s famous Tiger Management.
Many generated high returns in their early years, but their strategies became less lucrative as more people and more money flooded into them. Hedge fund-light strategies mimicked them, while low-cost index and exchange-traded funds came to dominate the markets. Once prized for their superior access to information, hedge funds have found that these days market-moving news is instantaneous and everywhere.
Meanwhile, hedge fund managers’ early success appears to have gone to their heads. After becoming superstars during the crash, they took on the mantle of market seers. Fearing another crisis, and distrustful of governments, Paulson and Einhorn, for example, both loaded up on gold. But when interest rates plummeted around the globe after central banks moved to prop up the financial system, the value of gold sank.
Perhaps no one exemplifies the arrogance of the hedge fund manager better than Eddie Lampert, the once-revered founder of ESL Investments, who bought the ailing but iconic retailer Sears and rode it all the way to bankruptcy. As former hedge funder Whitney Tilson told the Wall Street Journal, “He bet his entire career on one stock. What on earth does he know about retailing?” In fact, the only consistent winners in recent years were those who rode the wave of easy money and bought into the tech giants—Amazon, Netflix, Facebook—that have driven the stock market’s massive gains. But who needs to pay 2 and 20 for that?
Some call hedge funds’ downfall the inevitable effect of hubris. But there’s another way to explain all this. Finance geeks talk about “regression to the mean.” Most hedge fund managers aren’t really geniuses. Shrewd, yes. But sometimes their outperformance also stemmed from luck, or a specific investment thesis that could not easily be repeated. The ego that helped them make and win those big bets also caused them to make and lose big bets. Regression to the mean.
So why do hedge funds still control trillions in assets? One word: Institutionalization.
After the tech bubble burst between 2000 and 2003, hedge funds began a shift from a cottage industry catering to the wealthy to one structured for institutions such as pension funds and universities. This so-called institutionalization is the main reason why the hedge fund industry has managed to grow its assets under management despite lousy returns.
The beginnings of institutionalization can be traced to Yale University’s David Swensen, a former Wall Street derivatives expert who began investing Yale’s endowment, previously a conservative mix of stocks and bonds, in hedge funds in the late 1980s—to huge gains. That eventually led other university endowments and nonprofit foundations into hedge funds, followed by a few intrepid pension funds such as CalPERS, the California state employees pension fund, whose turn-of-the-century stock market losses led them, in 2002, to embrace alternative investments like hedge funds in hopes of bolstering their shrinking coffers.
By 2003, hedge fund assets had hit $625.6 billion, and a gold rush was underway. The year 2007 saw the biggest annual increase ever: $194.5 billion of new money went into hedge funds, pushing the total up to $1.86 trillion.
Then came the financial crisis of 2008. A number of hedge funds would crash and burn during that time, and many refused to let investors out, causing an uproar. Overall, however, hedge funds fared better than most investments. Meanwhile, pension funds found themselves underwater and underperforming. Those that hadn’t already invested in hedge funds jumped in. Others increased their stakes.
By then, hedge funds had embarked on an asset-accumulation game. Their billionaire founders toured all 50 states and flew around the world—from South Korea to Saudi Arabia—speaking at events hosted by banks like J.P. Morgan and Goldman Sachs. They talked their book on CNBC and at investment conferences from London to Singapore (and Las Vegas).
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To be clear, hedge funds’ $3.2 trillion hasn’t just come from raising money. In fact, from 2008 through 2017, about $4 billion more left hedge funds than came in, according to HFR. The total number of funds has also declined from the peak. But starting in 2010, investors started trickling back in. And as the law of compound returns kicked in, hedge fund assets rose—doubling since the crash. And as hedge funds became institutionalized, a support industry grew to depend on them, especially consultants whom institutional investors relied on to shepherd their investments.
Indeed, there has been only one organized opponent of the institutional move into hedge funds: labor unions, specifically the Service Employees International Union and the American Federation of Teachers (AFT). The retirement funds of their public-sector members were channeled into hedge funds whose returns, the unions argued, didn’t compensate for the high fees being charged. That assessment has mostly turned out to be right. But the public servants who ran the pensions, with little understanding of some of the esoteric strategies many hedge funds pursue, were also wowed by the larger than life, swashbuckling personalities of their founders.
“The hedge fund manager is intimidating,” says Stephen Lerner, a longtime labor activist who was one of the founders of a group called Hedge Clippers. Financed in part by the AFT, the group researched the financial impact of hedge funds’ high fees and lobbied public pensions to get out of them.
In 2014, CalPERS, once perhaps the biggest cheerleader for hedge funds among public pensions, was the first to exit. The country’s largest pension plan, which then had some $298 billion in assets, announced that it was pulling its $4 billion investment in hedge funds. As the Wall Street Journal reported, “CalPERS officials began raising questions about whether hedge funds are too complicated or can effectively counterbalance poorly performing equities during a market crash”—a direct shot at the funds’ very reason for being. In October a $4.2 billion California pension fund, the Kern County Employees’ Retirement Association, withdrew smaller investments—about $36 million total—from two hedge funds managed by Carlson Capital Management and Menta Capital. The reason, according to the newspaper Pensions & Investments? “Redundant strategies and lower levels of conviction.” Hedge Clippers has also made modest progress, notably in Illinois, New York and New Jersey, which have reduced or exited their hedge fund investments. But it has not been as easy a sell as logic would dictate.
One big reason why pension funds continue to put money into hedge funds is an underlying fear that despite—or perhaps because of—a nine-year bull market, things could turn, and hedge funds will once again shine. “Everybody’s afraid that they’re going to look bad if that happens,” says Lerner. “Everybody thinks they’re going to pick the ones that outperform.”
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Perhaps dismayed by the losses so many star managers have racked up in recent years, investors have sought another route. They’ve been pouring money into quant strategies—those driven by algorithms that can trade on every market-moving headline or data point in a nanosecond. The upshot is that quants have become the biggest hedge funds in the world, controlling some $300 billion, according to Institutional Investor’s list of the top 100 hedge funds.
In the end, the reason hedge funds will survive may have more to do with psychology than economics.
Despite the decades of research showing that over time, nobody beats the market—especially those who collect enormous fees in the process—investors of every size still long to believe in the cult of personality, the allure of alleged genius, the mysterious black boxes of secret investment formulas. Those who invest large sums of money hunger to believe that there is always someone who has a magic formula to outperform the market—he’s just under the radar right now. After all, no one really needs to get paid a lot for investing in a total stock market ETF. The media treats hedge fund managers as both superheroes and villains, while they manipulate everyone by maintaining their oh-so-intriguing aura of secrecy. Now there are new hedge funds in crypto and AI and Ethereum. Even though prices are falling, they are a hot commodity. Some institutional investors even claim they don’t care about beating the market; they just want a steady return of, say, the 7 or 8 percent that some hedge fund strategies promise.
Whatever the reason, in September Institutional Investor reported that after years of grudgingly reducing fees, 80 percent of hedge fund managers in a recent survey announced that they had cut enough and weren’t going to take them any lower. The show, it seems, must go on.