That was with the “old” definition of hedge funds that actually hedged. In the modern definition, any fund can be called a hedge fund, so the investment strategies are all over the place.
Because of risky investment practices, individual hedge funds also have a higher chance of collapsing.
Hedge fund management companies experience what economists call “moral hazard“. The management companies can make enormous amounts of money when the fund rises in value, while they are protected from losses in the case of a loss.
The single most crucial factor in how well a particular hedge fund does is the skill of the manager. Accordingly, successful hedge fund managers quickly become enormously wealthy superstars in the world of finance.
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Hedge fund managers often take for themselves a large portion of the profits; a %20 performance fee is not uncommon. Additionally, managers will take %1-2 of the total funds managed.
To give a couple of extreme examples, James Stewart of Renaissance Technologies kept %44 of the profits he made for his investors, pocketing 670 million dollars while giving his investors a %24.9 return on their investment.
Elena Ambrosiadou became the highest-paid businesswoman in Britain when she paid herself almost 16 million for managing a successful hedge fund, and Ed Lampert of ESL Investments paid himself a billion dollars. These sorts of figures are usually tossed around in reference to governments, not individuals.
When investing in a hedge fund, remember that most of them don’t match the returns of the highest-flying performers.
When it comes to average expected returns, the hedge fund industry does not do as well as the leading funds.
This may be because the number of hedge funds has increased tenfold over the last few years, putting a lot of inexperienced managers in control of a lot of money.
While some hedge funds did spectacularly well, just as many did spectacularly poorly. The rate of hedge fund closures has been measured at %20 per year, making it an exercise in recklessness to develop long-term investment strategies with unproven hedge funds.
Because of these collapses, the average return for offshore hedge funds for the period of 1989-1995 was only %13.6 according to a study by Yale and NYU. This is compared with %16.5 growth for the S&P 500 over the same period.
Perhaps nothing epitomizes the highs and lows of the hedge fund industry so much as Long-Term Capital Management, a hedge fund founded by John Meriwether.
The company’s strategy was to exploit the difference in the rate at which government bonds issued by the United States, Japan, and Europe converged in value over a long period of time. The strategy was brilliant, unorthodox, and initially amazingly successful, yielding consistent profits of up to %40 per year. But disaster loomed ahead.
In late 1998, the Russian government defaulted on their government bonds, and skittish investors abandoned European and Japanese bonds in droves, favoring those issued by the United States.
The convergence that was supposed to happen became a divergence, and the former huge profits correspondingly changed to stupendous losses.
The fund was forced to liquidate, losing 4.6 billion dollars and threatening the stability of the entire system. With financial markets on the verge of chain-reaction collapse, the Federal Reserve Bank of New York was forced to stage a bail-out.
The basic principle by which Long-Term Capital Management operated was correct, and the values of the bonds did eventually converge (after the company had collapsed.)
This goes to show that even the best-laid plans of extremely competent managers can lead to financial ruin due to unforeseen circumstances and that an otherwise rational market can experience periods of irrationality capable of wiping out investments before calm is restored.