Hedge Funds
The flourishing financial markets are a result of substantial funds known as hedge funds. A hedge fund is typically a limited partnership of private investors whose capital is handled by fund managers. These managers employ a variety of tactics, such as leveraging and trading of non-traditional assets, to increase the potential return on an investment.
The name hedge fund is derived from an investment strategy called hedging. In finance, hedging refers to limiting or reducing risk exposure in an effort to increase the security and return of an investment despite volatile markets. A market or security is said to be experiencing volatility when there are periods of unpredictable, occasionally abrupt price changes. Volatility is frequently associated with price declines, although it can also apply to sharp price increases. Hedge funds will use a variety of financial tools or market tactics to reduce risk. One strategy for minimizing market risk is modern portfolio theory, which enables investors to use diversification tactics to lower volatility.
The creation of the first hedge fund in 1949, can be credited to Alfred Winslow Jones. Who, took long positions on undervalued securities and short positions on overvalued securities as insurance against market downturns. Thus, he was hedging his position, which eventually led to the term “hedge fund”. His moderate but ground-breaking theory attempted to mitigate the risks associated with stock investing by utilizing a market-neutral portfolio.
Market neutrality is a particular investment approach that integrates inexpensive stocks with the short selling of overvalued securities to offset the impact of the general market for a particular type of security. This is essentially how hedge funds were established. By purchasing assets that Jones anticipated would appreciate in value relative to the overall market and selling short assets whose price he anticipated would decline, Jones was able to attain market neutrality.
When Jones added an incentive fee and made his fund a limited partnership in 1952, he invented the first hedge fund product. A hedged strategy, leverage and a 20% charge were all incorporated in this first pooled investment product. Hedge fund interest skyrocketed in the 1960s as a result of a 1966 Fortune magazine article highlighting Jones's superior investment performance.
Jones had beaten the top mutual fund over the preceding five years by 44%, even when expenses were taken into consideration. Following this, numerous hedge funds were established, including the George Soros-led Quantum Fund, which gained notoriety in the 1990s after it was reported that Soros had earned $1 billion in profits.
As the economy faced market risks, the recession of 1969–1970 and the stock market crises of 1973–1974 led to the closure of numerous hedge funds. Over the course of a year that ended on May 31, 1970, Jones's fund itself underperformed the S&P 500 by more than 10%. In the United States, the stock market index, known as Standard and Poor’s or S&P 500 tracks 500 domestically based publicly traded companies. Many investors believe it to be the most accurate way to assess the performance of the American stock market in its entirety. Jones, however, only experienced losses in three of his funds over 34 years of existence.
The hedge fund industry kept growing throughout the 1980s, with many funds seeing phenomenal growth in assets under management as a result of excellent returns and rising demand from affluent individuals and families. Although hedge funds expanded and excelled in the 1980s, it wasn't until the 1990s that the industry truly took off. Many influential funds, including the first hedge funds from Bridgewater Associates, were introduced during this decade. The hedge fund industry saw an influx of new strategies. The decade of the 90s saw the rise of hedge funds that were heavily invested in arbitrage, macro and multi-strategies.
The history of the hedge fund and financial industries is heavily impacted by the highly controversial figure Bernie Madoff. He was a hedge fund manager and chairman of the NASDAQ stock exchange. The National Association of Securities Dealers Automated Quotations or simply, NASDAQ, is the second-largest stock market.
Bernard L. Madoff was known as an affable, charismatic and highly respected individual who moved comfortably among power brokers on Wall Street. This was before stealing tens of billions of dollars from thousands of his investors, when he developed the largest ponzi scheme in history.
A Ponzi scheme is an investment fraud in which money obtained from new investors is used to pay out old investors. Ponzi scheme operators frequently make the claim that they will invest your money and produce substantial returns with little to no risk. However, the scammers rarely invest the money in their Ponzi schemes. Instead, they pay individuals who made earlier investments while also possibly keeping part for themselves. Before his arrest in 2008, Madoff served as the chairman of Bernard L. Madoff Investment Securities LLC, which he started in 1960. According to his own court testimony, Madoff claimed that his Ponzi scheme began in 1991. Despite his testimony many people believe his scheme began far earlier than 1991.
Hedge funds influence stock prices while enhancing price efficiency and providing liquidity, which benefits the market as a whole. The four common types of hedge funds are referred to as global macro hedge funds, equity hedge funds, relative hedge funds and activist hedge funds. Global Macro hedge funds aim to profit from significant market fluctuations brought on by economic or political events. Equity hedge funds invest in profitable stocks while protecting against declines in equity markets by shorting expensive stocks or stock indexes, which may be global or local. Relative hedge funds exploit momentary price variations between related assets by taking advantage of pricing inefficiencies or arbitrage. Activist hedge funds intend to invest in firms and take activities to increase the stock price, including putting pressure on companies to reduce expenses, reorganize their assets or alter their board of directors. Due to their various end objectives, hedge funds are distinct from one another.
In a similar fashion, hedge funds differ from other types of funds, such as mutual funds. Both funds are financial platforms that give investors access to managed portfolios, but that's where their similarities end. In an effort to generate profitable returns for investors, hedge funds focus on only accredited investors and engage in more complicated trading tactics. An individual is deemed to be an accredited investor if they have earned at least $200,000 over the past two years and anticipate doing so again in the following year, or if they have a net worth of at least $1 million. This is required by regulation to ensure that the investor can accept the risks of investing in these typically unregulated securities.
Hedge funds are subject to less stringent regulation by the Securities and Exchange Commission (SEC) than mutual funds. In an effort to encourage ethical business practices, the disclosure of critical market information, and the prevention of fraud, the Securities and Exchange Commission regulates securities exchanges, securities broker-dealers, investment advisors and various funds. In order to efficiently invest in securities such as stocks, bonds, money market instruments and other assets, mutual funds aggregate the funds from shareholders. Financial managers run mutual funds, allocating the assets and attempting to generate capital gains or income for the fund's investors. The portfolio of a mutual fund is set and kept up to date in accordance with the specified investment goals in the prospectus, which is a crucial disclosure document that a fund must publish when selling investment securities to the general public.
Hedge funds are compensated by fund investors through a fee structure based on the assets under management (AUM). For substantial returns that surpass a benchmark or hurdle rate, fund managers often get a percentage of the positive returns in addition to a flat fee. The benchmark or cut-off rate, commonly referred to as the weighted average cost of capital (WACC), is frequently used as the hurdle rate. The WACC is generally used to evaluate a proposed investment, taking into account the potential risks involved initially.
The most common investment strategies for hedge funds are long and short equity, market neutral, merger arbitrage, convertible arbitrage, capital structure arbitrage, fixed-income arbitrage, event driven, global macro and short only. The simultaneous purchase and sale of the same asset in multiple marketplaces is known as arbitrage. The objective is to make money off of minor variations in the asset's quoted price. It takes advantage of brief fluctuations in the cost of identical or comparable financial products across various marketplaces. Funds differ from one another due to their use of varying investing strategies. A long and short equity strategy was employed by the first hedge fund. This approach, developed by Alfred W. Jones, is still one of the most popular strategies and is used today by a majority of equity hedge funds.
Typically, when the market is declining, hedge funds perform well. Many financial theorists came to the same consensus, “With the threat of recession growing, we examined hedge fund performance during recessionary periods over the last three decades, finding that they have demonstrably outperformed when stocks have declined.” When markets are volatile or in decline, hedge funds typically perform better because they have more opportunity to earn from short selling securities or from trading assets with poor correlation, which means that their values typically don't move in parallel with the market.
The stability of the hedge fund business is crucial to the US economy as well as the world economy. The sector of the financial system that deals with shares, bonds and other long-term investments in order to raise funds is commonly referred to as a capital market. Without access to capital, which is reliant upon open capital markets, businesses cannot function properly. If the capital markets collapse, the world economy implodes, resulting in lost jobs. This result is clearly detrimental. Hedge funds often perform an important function by acting as the buyers of last resort for securities that no one else wants to buy, in addition to supplying liquidity to economies.
Since the financial crisis of 2008, the hedge fund sector has become substantially more stable, which is good for the United States economy. Due to the Dodd-Frank Act, hedge funds have frequently overtaken investment banks as a major source of liquidity for the capital markets. The Dodd-Frank Act, officially known as the Dodd-Frank Wall Street Reform and Consumer Protection Act, is a federal law of the United States that gives the government control over the regulation of the financial sector.
The law, which became effective in July 2010, established financial regulatory procedures to reduce risk by requiring responsibility and transparency. Institutional investors have contributed significantly to the growth of the hedge fund sector. Around one-third of hedge fund assets came from pension funds, endowments and foundations, while roughly 60% came from various institutional investors. The profits generated by hedge funds benefit people across the economic spectrum.
Hedge funds progressed throughout the 20th as well as the 21st century. In the 2000s, hedge funds became even more mainstream. Institutional investors including pension funds, insurance corporations, and sovereign wealth funds started buying hedge fund products after the dotcom bubble broke. “The period between 1995 and 2000 is known as the "dot-com bubble," sometimes referred to as the "Internet bubble." It was during this time that investors poured money into enterprises with an online presence in the expectation that they would soon start turning a profit.
Between 2000 and 2010, 55% of the institutions that Preqin tracks made their initial investments in hedge funds. Preqin is a data platform that gives users access to data sets and technologies related to hedge funds and private equity. The platform offers market data as well as details on particular investors, advisors, managers, funds, transactions and service providers. It also offers data for use across the whole investment lifecycle.
The regulatory framework for the hedge fund business underwent significant revisions in 2010. The industry had previously been completely unregulated. For instance, Jones got around the Investment Company Act of 1940's limitations by capping the number of stockholders in his limited partnership at 99 or less. The early 2007 to the end of 2008 era, commonly referred to as the global financial crisis (GFC), produced high stress in the world's banking institutions and financial markets. Hedge funds recovered effectively from the GFC despite greater regulatory scrutiny, with sector assets topping $2 trillion again in 2011 and exceeding $3 trillion as of 2019.
According to Bloomberg, the top fifteen hedge fund managers made an estimated $23.2 billion last year. Tiger Global Management's founder, Chase Coleman, set the pace and earned more than $3 billion for himself. The top twenty highest-performing hedge fund managers of all time, according to The Financial Times, produced more than $63 billion in investor returns during the market upheaval caused by the coronavirus, making it the industry's biggest year of gains in a decade. In conclusion, the future of the financial sector could quite possibly depend on the “infamous” hedge funds, which have come to be extremely popular with investors due to their remarkable returns on investments.
