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Background

In 1949 Alfred W. Jones established the first hedge fund-type structure when he borrowed funds (used leverage) to increase his long positions while adding a portfolio of short stocks in an investment fund with an incentive fee structure. Carol J. Loomis used the term “hedge fund” in her 1966 Fortune magazine article, where she discussed the structure and investment strategy used by Jones. Jones had set up his pool of investors as a limited partnership and was, thus, able to avoid the reporting requirements to which mutual funds were subjected. What drew Fortune’s attention to Jones was that his fund significantly outperformed traditional investments. From 1960–1965 Jones’ investments returned 325 percent while the Fidelity mutual fund returned 225 percent. During the 10-year period from 1955–1965 Jones’ fund returned 670 percent compared to the Dreyfuss fund, which only returned 358 percent.

After the Fortune article, other money managers found Jones’ investment style both profitable and intriguing and, thus, a growth spurt in the hedge fund industry began. In an attempt to copy Jones’ style (and hopefully performance), many money managers began selling short securities without prior experience. Haphazard short selling by new hedge fund managers adversely affected their performance during the bull market of the mid-late 1960s. These hedge fund managers were not actually “hedging” their positions at all; they were leveraged to the long side of the portfolio (betting that the market would go up), which was particularly risky entering the bear markets of the 1970s (when the markets declined). These managers produced substantial losses in 1969-70 and a major bloodletting ensued in the 1973-74 bear market.

The more experienced hedge fund managers survived the 1970s bear market. But, unfortunately many other hedge fund managers closed the doors. In 1984, when Sandra Manske formed Tremont Partners and began researching the hedge fund industry, she was only able to identify 68 funds. It is hard to determine an exact figure for the funds at this time due to the lack of marketing and public registration.

The hedge fund industry remained relatively small until the early 1990s, when the financial press once again highlighted the returns achieved by hedge fund superstars George Soros (Quantum Fund) and Julian Robertson (Tiger Fund and its offshore sister, Jaguar Fund). What differed about this new growth of hedge fund managers was that the hedge fund managers added a variety of trading strategies, including the infamous global macro strategy pursued by George Soros. Soros traded in the currency markets by buying and selling various currencies and most notably made over $1 billion betting against the British pound. Robertson employed modern financial derivatives such as futures and options, which didn’t exist when Jones started his fund.

The ability to use futures, options, swaps and other complex derivatives led to an explosion in the number of trading strategies. These strategies were not allowed to be employed in the mutual fund industry. Therefore, managers who felt that they could exploit the markets using these tools had to set up hedge funds. At the end of 1999, Tremont Partners estimated as many as 4,000 hedge funds existed, 2,600 of which were tracked in its database.

Estimates show that 610 hedge funds existed in 1990. By 2000 that number had increased to 3,873 and by 2006 there were reported to be more than 9,460 hedge funds. The rapid growth in the number of hedge funds during this time period was tied to the ability of hedge funds to outperform traditional markets in bear markets and investors’ increased interest in the advanced trading strategies that they employed. The growth was also fueled by increased interest in the industry from institutional investors (pension funds, sovereign wealth funds, endowments, foundations, etc.) and from the number of hedge fund managers entering the industry. In 2001, contributions by institutional investors comprised only 5 percent of all capital at hedge funds. That percentage has increased significantly in recent years. “Hedge funds have become an important part of the portfolios of many institutional investors,” said Amy Bensted, head of hedge fund products at Preqin, in a press release about the trend. “Almost 5,300 institutions globally are active in the asset class today [2018]; collectively they invest more than $2 trillion in hedge funds, accounting for 58 percent of the total capital in the industry. However, more than half of this $2 trillion is invested by just three investor types: public and private pensions and sovereign wealth funds.”

The 2008–09 financial crisis caused many hedge funds to liquidate their assets, and return-on-investment generated by surviving companies declined significantly. Although the number of funds has declined, the amount of assets under management by hedge fund firms has steadily increased. According to Hedge Fund Research Inc., hedge fund firms control $3.2 trillion in assets. That’s still significantly less than what the mutual fund industry controls ($16.3 trillion in 2016, according to Statista.com), but that doesn’t take away from hedge funds’ massive growth and their increasing ability to directly affect the overall markets through the sheer weight of assets they can invest.

This growth has come even as the hedge fund industry experienced its first real regulatory crunch and largest financial scandal ever (that of Bernard Madoff, who operated history’s largest Ponzi scheme in which investor losses ranged from $50 billion to $65 billion). In 2006, the U.S. Securities and Exchange Commission (SEC) required hedge funds to register as investment advisors. The move, considered a compromise between funds and the SEC, allows for oversight of funds—including random checks of a given fund’s accounting, for example—without requiring disclosures of holdings, strategies, past investments or other things that could ultimately give a fund’s competitors a look into a fund’s direction. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010, further increased the regulation of the hedge fund industry.

Although the regulation of hedge funds decreased in the first few years of the Trump Administration, surveys of hedge fund managers show that the industry continues to rank the “threat of too much regulation” as a potential negative effect on industry profits. 

High-frequency algorithmic trading—in which computers are used to process vast amounts of data and make quick purchases and sales of securities (sometimes with a holding time of less than a second)—has changed the trading strategies of some firms. About 20 percent of funds use quantitative strategies to generate returns, according to KPMG.