Hedge Fund - an Angel or a Devil

Hedge fund – An Angel or A Devil

1155081494 Tiantian Zhou

As Barclays writes in a recent hedge fund report named “Against All Odds”, hedge fund has generated negative cumulative alpha since 2011 to 2016, which results from the size of the hedge fund industry, the macro economy condition and the change of managers’ risk appetite^[1]. It seems that hedge fund has developed to a bottleneck since it was created by the “big daddy” Alfred Winslow Jones in 1949. In these seventy years, Hedge fund has been a more and more critical player in this market because of its unique characteristics which tell it apart from other publicly traded mutual funds.

Hedge fund is an investment fund that invests pooled capital in the market using various strategies such as derivatives and leverage to hedge its exposure to market movements and earn additional returns, alpha. It is different from other publicly traded mutual funds in many aspects, which can be dated back to the time it was created.  

The most important characteristic of hedge fund is that it is not regulated as much as other funds. When Jones’s hedge fund enjoyed surprising success in 1950s and 1960s, the authority tried to regulate it but Jones claimed that it was private and thus should not be regulated. To keep its private, hedge fund seldom advertises itself to attract investors even today.

Secondly, since it is regulated less, Jones’s innovations at the beginning are able to be kept until now – short selling and unique fee structure^[2]. Short selling ensures the probability for hedge fund to outperform the market whether in a bull market of a bear market. As for the fee structure, hedge fund managers are not only eligible to get the management fee but also a certain percentage of the profits as the performance fee, which provides unique incentives to managers.

When hedge fund firstly proved its success, people believed that it was only luck of Jones and other managers to outperform the market. Efficient Market Hypothesis was still the dominant theory at that times, based on which stock price is a random walk and all the efforts to outperform the market was in vain. However, the continuous success of hedge fund in these decades shows that market is not as efficient as shown in EMH and hedge funds’ strategies do work in beating the market.

After that, the critical role of hedge fund to financial markets havs been admitted by the public. For investors, hedge fund managers act as professional agencies who help wealthy investors to make investment decisions and manage portfolio risks.

For the whole financial markets, hedge fund managers trade in different financial markets in different areas frequently, which provides liquidity to the market especially in hard time. One example is the distressed fixed-income markets in the summer of 2003. It is the hedge fund which sold options following a spike in options prices that helped the market restore liquidity and limited the losses of derivatives and fixed-rate mortgages investors.^[3] In addition, by pooling idle funds from the rich and investing in high-return markets, hedge fund helps to achieve efficient allocation of capital.