What Are Hedge Funds?

Hedge funds are alternative investments. Just like mutual funds, they use pooled capital to make investments in liquid assets. Hedge fund managers typically identify market opportunities to generate returns for their investors using highly aggressive investment strategies. This makes these funds far riskier than mutual funds and other traditional investment vehicles.

Their significant minimum investment levels and outrageous fees weed out all but the wealthiest clientele. This means they're only open to accredited investors, including institutional investors and those with a high net worth.

The very first hedge fund was launched by A.W. Jones & Company in 1949 when sociologist A.W. Jones raised $100,000. He used the money by holding long-term stock positions while short-selling others. As such, Jones became the first money manager to develop a partnership with investors to mix short selling while using leverage and shared risk.

These investments gained popularity in the 1990s after a number of mutual fund managers moved off on their own to mimic Jones' success. Despite a number of failures, the industry has grown. But when the financial crisis hit, hedge funds were among those hardest hit by the fallout. But were they a victim of the crisis or did they help cause it? That remains a matter for debate. This article looks at how the financial crisis impacted the hedge fund industry and where it stands after the

Key Takeaways

  • Hedge funds are alternative investments meant for accredited investors.
  • Once the darlings of Wall Street, they attracted billions of dollars and boasted stellar returns.
  • The financial crisis and the Great Recession that followed put a damper on hedge fund returns.
  • Some experts claim that the industry was, in part, to blame for the crisis because it pushed risky investments like mortgage-backed securities.
  • Although hedge funds are recovering, the industry has changed, with record volumes of outflows and changes to fee structures.

The Financial Crisis and Hedge Funds

The financial crisis didn't happen overnight. It was the result of years of cheap credit, loose lending standards, and risky ventures by investment managers and investors hungry for returns after the dot-com bubble burst. Coupled with the low-interest-rate environment and lax lending environment, low home prices encouraged high-risk borrowers to become homeowners. Banks and fund managers bundled, packaged, and sold their subprime loans into mortgage-backed securities (MBSs) as investments.

When home prices started to rise, interest rates followed. Subprime borrowers who were no longer able to afford their homes walked away from their loans rather than refinance. These massive defaults created a domino effect in the market, causing the global interbank market to freeze and the stock market to crash. Credit dried up and some of the world's largest banks and investment firms, including hedge funds, failed because of their role in these risky investments.

Some supporters argue that hedge funds weren't the only ones to blame for the crisis. But others put them squarely at the root of the crisis, blaming them for responding to the demands of return-hungry investors by taking part in these high-risk investments. They cited warning signs, including:

  • the pending explosion of the housing bubble
  • increased risk of exotic investments like MBSs
  • losses due to investment in illiquid assets

And they may not have been mistaken. The first three quarters of 2008 saw roughly 7% of the hedge fund industry shutter its doors and more than three-quarters of the industry either liquidated their holdings or put restrictions on redemptions.

Hedge fund firms generally require that an investor's net worth exceed $1 million.

Large-Scale Shifts

The crisis caused waves in the market and hedge funds were not immune. Although many markets have recovered significantly, due, in part, to government stimulus. But the same hasn't applied to this industry. In fact, the vast majority of these firms haven't been able to produce returns even close to where they were before the crisis.

The overall industry has struggled compared to other markets. Values dropped following the financial crisis and didn't show signs of recovery until at least 2013. The third quarter of 2015 saw the largest plunge in net outflows since 2008, to the tune of $95 billion. Research shows that the industry grew 2.8%, on average, between 2015 and 2020. Returns during the first quarter of 2021 were the best since 2006, up just under 1% to 4.8%.

Another shift comes through fee structures. These funds historically adhered to the two and twenty model, charging 2% of their total assets and 20% of their gains. This was acceptable before the crisis because funds typically produced double-digit annual returns. But less-than-stellar returns since then aren't justifying these high fees.

Many funds are struggling to match the returns of the S&P 500, causing certain funds to change their fee structure. Some experts predict that firms will have to rethink their fees to keep and attract new investors. This could mean a drop to a 1% management fee and a performance fee of 15%, something some funds are already working toward.

The hedge fund industry grew to 8,405 operating businesses in the U.S., with a total value of $69 billion by June 2020.

Where Does That Leave Us?

Regulatory changes swept through the financial industry after the crisis. Lawmakers introduced legislation that would increase accountability and transparency in this industry, which was largely unregulated until then. Portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in the U.S. in 2010, restricted how banks could invest and trade on a speculative basis. Banks were also prohibited from any involvement with hedge funds under the Volcker Rule.

Despite all the doom and gloom, this doesn't mean that the hedge fund industry is dead. Many investors still focus their attention on major names in the space and quarterly filings by some of the biggest names in money management never fail to draw interest among investors of all types. The top five funds as of June 30, 2020, were:

  • Bridgewater Associates ($98.9 billion)
  • Renaissance Technologies ($70 billion)
  • Man Group ($62.3 billion)
  • Millennium Management ($43.9 billion)
  • Elliott Management ($42 billion)

According to research, the first six months of 2017 were strong for the industry. A portion of the hedge fund industry may have been able to generate strong profits by going short on metals before commodities were hit hard by trade tensions involving the U.S. Prominent money managers, like Citadel's Ken Griffin, have maintained their outstanding returns even through the post-crisis phase.

Some analysts believe this represents hope for the industry or that this is a sign that hedge funds are making a comeback. As investors grow increasingly interested in low-cost, often more stable types of investment, such as exchange-traded funds (ETFs) and index funds, hedge funds have lost some of the position of prominence that they enjoyed prior to 2008, perhaps never to get it back.

The Bottom Line

No matter what role hedge funds played in the financial crisis, there's no doubt that the industry was greatly affected by the fallout. Investors pulled out their money due to losses as a result of the aggressive and risky strategies taken by fund managers.

Once darlings of the industry for their record-beating returns, these alternative investments have struggled to get back to their previous levels. But changes, including lower fee structures and more transparency, may be stirring renewed interest from investors.