Overview
This lecture traces the evolution of hedge funds from their original purpose as risk management tools to their current status as exclusive, high-fee investment vehicles for the ultra-wealthy, contrasting them with regulated public markets.
Origins of Hedge Funds
- Alfred Winslow Jones created the first hedge fund in the 1950s, aiming to balance risk by betting for and against companies.
- "Hedge" means protection, similar to buying insurance for investments.
- The original goal was to minimize risk regardless of market direction.
Historical Backdrop: Stock Market Regulation
- The 1920s stock boom ended with the 1929 crash, causing massive losses and the Great Depression.
- In response, the Securities Act of 1933 required companies to disclose truthful financial information.
- The Securities Exchange Act of 1934 established the SEC to oversee and regulate public markets.
- Regulation led to transparency and fairness in public investing.
Structure and Operation of Modern Hedge Funds
- Hedge funds are private pools of capital limited to accredited (wealthy) investors.
- They avoid most public market regulations through this exclusivity.
- Investors commit funds to a manager with little to no ongoing transparency.
- Lock-up periods prevent investors from withdrawing funds quickly, allowing long-term strategies.
- Hedge funds can invest in a wide array of assets, including private, illiquid, or exotic markets.
- They engage in high-risk strategies such as leverage, derivatives, short selling, and global macro bets.
Compensation: The "2 and 20" Model
- Hedge fund managers typically earn a 2% annual management fee plus 20% of profits (performance fee).
- Managers collect the management fee regardless of fund performance.
- "High water mark" rule means performance fees are only collected after recovering previous losses.
- Despite high fees, managers often profit even if investors do not.
Appeal and Criticism of Hedge Funds
- Hedge funds provide access to unique strategies and investments unavailable to most investors.
- They offer potential for "asymmetric returns" (large upside relative to risk).
- Participation is associated with exclusivity, networking, and status.
- Wealthy investors use hedge funds for risk diversification and strategic control.
- Many funds now underperform compared to cheap, simple index funds after fees.
- Criticisms include high fees, lack of transparency, and inconsistent returns.
Key Terms & Definitions
- Hedge Fund — A private investment partnership for accredited investors, using varied strategies to seek high returns.
- Accredited Investor — An individual meeting wealth or income thresholds to access private investments.
- SEC (Securities and Exchange Commission) — U.S. government agency regulating public financial markets.
- 2 and 20 Rule — Fee structure: 2% of assets as management fee, 20% of profits as performance fee.
- High Water Mark — Only allows managers to collect performance fees when fund value exceeds prior peaks.
- Asymmetric Returns — Returns that offer large potential upside compared to downside risk.
Action Items / Next Steps
- Review definitions of hedge funds, accredited investors, and the 2 and 20 rule.
- Understand the differences between public and private investment vehicles.
- Know the historical reasons for market regulation and its effect on transparency and fairness.