Hedge Funds — Magic or Sham?

Mysterious, hidden, and seemingly magical… what do hedge funds do and are they a sham?

Hedge funds and their clandestine workings — they are the mechanisms by which wealthy private investors grow their fortune 10 fold while the middle class is forced to line up for modest pension and mutual fund returns. Or at least that seems to be the common trope surrounding hedge funds today. But is there any validity to this claim? How do these mysterious hedge funds work in the first place? Grab a bag of chips and put on your smartest pair of glasses because today we’ll be diving into the strange world of hedge funds.

A Walk Down History Lane

In order to examine how hedge funds work, we have to understand how they came about in the first place. Let’s rewind all the way back to the turn of the 20th century.

Image credit to Business Insider

The year was 1900, the fateful year that a would-be Communist by the name of Alfred Winslow Jones was born. Nothing about young Jones’s early years spelled the making of a financial genius. Instead, young Jones had a rather bizarre career path, to say the least. After graduating from Harvard, his wanderlust propelled him to tour the world doing odd jobs including a purser on a tramp steamer, an export buyer, a statistician for an investment counselor, and working for the State Department. He moved from Germany to London and then to America. Although he would later become known as the ‘big daddy’ of hedge funds, he only began to dabble in finance at the ripe old age of 49 and only because he needed money to raise his family.

In 1949, Jones left his job as a journalist to raise $100,000 to try his hands at investing. Little did not-so-little Jones know, his investment record over the next 20 years might be some of the most remarkable in all of financial history.

His mysterious investment strategy enabled him to make just under 5000% return by the year 1968, rivaling even the great Warren Buffet. His ingenious methods set the groundwork for later proteges like Michael Steinhardt, George Soros, Julian Robertson, Bruce Kovner, Paul Tudor Jones, and many others.

Do Hedge Funds Really Beat the Market

Over the years, there have been many many great hedge funds whose track records indisputably prove they’ve beaten the market year after year. Or do they?

Image credit to Brad DeLong

During an interview between Warren Buffet and Michael Jenson, one of the most renowned supporters of efficient market theory, Michael Jenson made the compelling argument that if you asked a million people to flip coins, some would flip five heads in a row. The point he was making is that if you have enough investors, some would end up beating the market year over year. It’s a game of chance, not a game of strategy.

So perhaps these hedge funds were really just lucky, right? Well here is what Warren Buffet had to say about Michael Jenson’s argument. He claimed that well it is absolutely true that luck may explain how some investors manage to beat the market year over year, but it does not explain how many of these so-called ‘lucky’ investors belong to the same family of investors. He then cites the example that many of the investors who follow Benjamin Graham’s value investing strategies beat the market year over year.

Image credit to Frederik’s Labyrinth of Life

The same can be said about hedge funds. In order to prove this point, we have to look no further than the example of Julian Hart Robertson, the founder of Tiger Hedge Fund. Over the years, many of Tiger Club’s best employees set up their own hedge fund and found tremendous success in beating the market.

So if it isn’t luck, what is it? What is it that makes these hedge funds so successful in beating everyone else? Spoilers: it has nothing to do with the hedge funds themselves.

Case Studies

Alfred Winslow Jones

Let’s first examine the case of Alfred Winslow Jones. What was the strategy that enabled him to seemingly beat the market for over 20 years, pulling in returns that no other financial institution could even dream of pulling in over these same years?

Using leverage and hedge was not a common practice during Jones’s time. During that period, investing was not seen as a lucrative or respectable career path. There was limited research and study into how to effectively pick stocks and the strategies that were implemented were rudimentary, to say the least. Instead of simply being long on stocks that seemed bullish. Jones used leverage to pick out stocks that were primed to go up and short stocks that were primed to go down. His short positions hedged his long ones and vice versa. If he was in fact superior at picking stocks, this strategy would enable him to reap more profit at a lower risk than conventional means, something that was thought to be impossible.

A new business structure was the second crucial piece of the puzzle that Jones needed to make his strategy work. While his methods did in fact reap superior upsides with lower risk, his method depended heavily on how well he could pick out his stocks. A bad selection would actually perform worse than the conventional method of picking stocks. To incentivize his men to pick out good stocks, he created the 2/20 fee structure which has become mainstream for hedge funds today. The 20% performance fee incentivized his men to win whilst his individual approach to allocating capital and bonuses meant competitive drove each man to win at all cost. Without even knowing it, Jones had created the winning organizational structure that persevered till today.

George Soros

As one of the most famous hedge fund managers in the world, George Soros is not only known for his financial genius but also for his philanthropy and philosophy. During its high years, his quantum fund managed to return an astonishing 30% compounded annual return, far outperforming the market.

Ahead of his time is not nearly enough to describe the way that George Soros invested. He had an uncanny ability to see the links between different events. For example, he noted that Soviet weapons worked well during the Arab-Isreali war of 1973, and rightfully predicted that Congress was about to increase spending on its own defense. He plunged into defense stock, becoming the biggest shareholder outside defense contractors. And he was right. In 1985, he predicted the US dollar would fall, citing that it was way too overvalued and did not make sense. While no one else thought anything aloof, Soros raked up hundreds of millions of dollars against which the US dollar would fall.

Are They Magic Or Sham

So now we return to the question of whether hedge funds are truly the magical wealth creation machines they claim to be or are simply overhyped garbage.

They are…both. But wait, before you get mad at me and say “Wherefore didst thou pose this bootless query, an thou hadst no firm response to render, ” hear me out.

Hedge funds that have managed to outperform the market did so because someone in their team had found an exploit or formed an understanding that was ahead of its time. This is the true key to the success of hedge funds.

But this is also the cause of downfall for many hedge funds. You see, no investing strategy stays a mystery forever, when one firm is constantly beating everyone else, the secrets will leak sooner or later. It is why A.W. Jones was unable to compete once other firms caught up with his leverage and hedge strategy. It is why Steinhardt, Fine, Berkowitz outperformed the market for 9 of the eleven years in the 1960s and 70s but lost its touch afterward. This is also the reason why hedge funds tend to operate in secrecy and avoid public attention as much as possible.

So there you have it… hedge funds are interesting, complex, and sometimes genius, but they are not some kind of magical get-rich scheme. Like everyone else, their true value lies in their connections, their strategy, and their people.