For starters, we all know what “hedging” means. It means to reduce the amount of risk you are open to, most commonly heard in the phrase, “hedging your bet.” While this definition once applied to the hedge fund, today it totally does not.
Hedge funds and the people who run them are particularly interesting because they are a sensational representation of the very wealthy. Known for being extravagant, highly opinionated, and very happy living in a place of extreme risk, hedge fund managers have been loosely referred to as “masters of the universe.”
Hedge funds were born in 1949 when Alfred Winslow Jones formed the first as a new sort of investing strategy where a fund manager would “hedge,” or try to avoid significant loss by going short in positions (shorting a stock means that you believe the value is going to decrease, so you bet against it – learn more here), as well as going long (invest in securities with the intention that these stocks and bonds are all going to increase in value). By carefully balancing the risk the fund was exposed to, potential risk was mitigated. This part is key, and is where the name hedge fund is derived from.
Today, hedge funds largely make grand scale speculative investments where they are betting on a huge upside based on their predictions for market movements and economic conditions – often with no hedging involved. These funds are playing to beat the market on a macro scale and their ability to do this is referred to as “alpha.” When investments of this scale are made, the potential for upside is massive, but the potential for loss is also massive and can have the ability to shut a hedge fund down. The thing about hedge funds is that they are typically built on the reputation of the managing partner or partners and their ability to beat the market and provide investors with huge returns – it’s similar to stock promoters (smaller scale, and likely more relatable as we all know one); have a few big public losses under your belt and you’re going to have a very challenging time raising money for your fund or next venture.
A particularly memorable hedge fund fail involved Bernie Madoff, the guy who was caught running a Ponzi scheme and highly publicized as the face of American greed culture. In 2008 he was sentenced to 150 years in prison, as well as a $170 billion in restitution fees. Here’s how he scammed investors out of $65 billion.
The details:
- As with any investment that offers an enormous upside or downside, hedge funds are only open to accredited investors, people who can stand to lose what they invest. In the US, investors must have a “net worth exceeding $1 million excluding their primary residence.” (Forbes)
- Hedge funds love leverage. “Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008 [and in the movie, The Big Short], leverage can also wipe out hedge funds.” (Forbes)
- Hedge fund managers are pretty free to act as they wish with their pool of investor money, as long as they disclose up front their investment strategy to investors.
- And the reason we read about their lavish lives and extreme wealth? The fee structure on a hedge fund is unlike anything else: 20% of all gains generated in addition to a 2% asset management fee. So when they win, they win BIG.
Feature image via blog.kosten.co
