A Short History of Hedge Funds

From Aristotle to Amaranth, the funds have lured investors with dreams of heady profits and terrified them with nightmares of risk.

With more publicity came more hedge funds. “A lot of trading desks and commodity-trading advisors began converting themselves into hedge funds,” says Brown. With that came new interest in foreign investment, as funds focused on currencies and interest rates. By the early 1990s, global macro investments comprised more than 60 percent of the hedge fund industry, according to Oliver Schupp of the Credit Suisse/Tremont hedge fund index. Although hedge funds are barred from advertising or soliciting business, high-profile success by investors such as Soros attracted global attention.

The Roaring ’90s

Not all of the attention was positive. In 1992 Soros’s Quantum Investment Fund shook the markets when he wagered $1 billion on the devaluation of the British pound. The speculative move drove Britain to pull out of the Exchange Rate Mechanism (Europe’s pre-euro system for stabilizing exchange rates), spiking interest rates by 5 percent in a matter of hours. The U.K. Treasury later estimated that “Black Wednesday,” as it was known, cost Britain £3.4 billion, or about $6 billion in 1992 terms.

Soon after, Soros was demonized by the prime minister of Malaysia for causing the Asian Financial Crisis. Calling him a ‘rogue speculator,’ Prime Minister Mahathir Mohamad said: “We have worked 30 to 40 years to develop [our] economy and here comes someone with a few billion dollars and, in just two weeks, he has undone most of our work.” Hedge funds were also blamed for the run on Thailand’s baht. “The baht is the only Asian currency for which the hedge funds collectively took significant short positions,” say Eichengreen and Mathieson.

As the IMF worked to stabilize Southeast Asia’s economies, America’s most alarming hedge-fund crisis was brewing in one of its own suburbs. In 1998, Long Term Capital Management (LTCM), a hedge fund in Greenwich, Connecticut, was managing $120 billion on just $4.5 billion in capital, according to an IMF report. The fund, which specialized in betting that interest-rate spreads would narrow, dealt in bonds, swaps, options, stocks, and derivatives. As creditors closed in, LTCM lost 90 percent of its equity in a span of two days.

The Federal Reserve Bank of New York, fearful of the risks that LTCM’s collapse could represent for the global markets, orchestrated a rescue plan with 14 other financial institutions to cushion the hedge fund’s fall. At the time, William McDonough, of the Federal Reserve Bank of New York said an intervention was necessary because an “abrupt and disorderly liquidation would have posed unacceptable risks to the American economy.” Eichengreen and Matheison referred to it as an “out-of-court bankruptcy-type reorganization” in which creditors took over the fund and tried to salvage it.

Despite such striking lows, the hedge fund industry swelled considerably in the 1990s. According to Hedge Fund Research, the industry grew (in terms of unleveraged managed assets) from $38.9 billion in 1990 to $536.9 billion in 2001. Since the equity bubble burst in 2000, most funds employ a mix of long-short, event-driven, and multi-strategy approaches, while interest in emerging markets and funds of funds has also grown, says Hoffman, of Credit-Suisse/Tremont. According to the Hedge Fund Association, there are now about 9,000 hedge funds making up an industry worth $1.1 trillion.

The Future of Hedge Funds

Although such growth has excited investors, the crises of the 1990s are still fresh in the minds of regulators. The meltdown at Amaranth, a hedge fund that lost 65 percent of its value last September before closing shop, reminded regulators about the risks posed of mismanaged hedge funds. The SEC has tried without success to require hedge funds to register and conform to tighter regulations. “Being more forthcoming would do a lot to allay the perception of systemic risk,” says Brown of NYU.

But hedge funds have resisted lifting the veil, and so far the mystique has paid off. These days several mutual funds are offering products that sound remarkably like hedge fund strategies. Investment banks such as Goldman Sachs and Merrill Lynch have launched “synthetic” hedge funds that attempt to replicate hedge fund returns by using historical hedge fund data while tracking up to 15 indexes of equity, commodity, and bond prices.

Academics have also weighed in, attempting to “clone” hedge-fund performance by using mathematical models to provide hedge-fund performance with common financial instruments. The goal: matching the reward with less risk and lower fees. Even Aristotle could not have foreseen such advances. Perhaps if Thales had such tools at his disposal, he wouldn’t have bothered with the olive business.

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