(Originally published on Dan Wang’s blog.)

J. Pierpont Morgan died in 1913 with a fortune of about $1.5 billion in today’s dollars. For his sway over Wall Street he was nicknamed “Jupiter,” after the Roman king of the gods.

In 2013, four hedge fund managers took home over $2 billion as income each, with the top manager pocketing $3.5 billion. How did a few asset managers earn more money in a single year than Pierpont Morgan did in his whole life?

It’s not always easy to tell. Hedge funds are secretive firms that have long invited suspicion. Their activities have provoked no less than Bill Clinton, who bemoaned the undue power of “a bunch of fucking bond traders” whose whims determined the success of his policy programs.

What should you know about the industry? This essay discusses how hedge funds are structured and the role they play in the financial system.

What are hedge funds?

Hedge funds are pooled-investment vehicles that are relatively unconstrained in their methods of generating returns. They can be thought of as small mutual funds which face fewer regulatory burdens and invest in less conventional ways.

The hedge fund industry has about $4 trillion in assets under management, which is significant, but not so large that it can dictate to the rest of Wall Street. Consider the fact that BlackRock, an asset management company, has about $4.3 trillion under management alone.

What makes a company a hedge fund?

Hedge funds are legally prohibited from advertising themselves to the public, and are allowed only to raise funds from government-approved “accredited investors.” These investors must prove a certain net worth and go through a registration process to become accredited.

In exchange for this limitation on raising capital, hedge funds face relatively little regulatory scrutiny, with few restrictions on the assets they can trade and the leverage they can employ.

The very first hedge funds distinguished themselves by employing leverage and short-selling. That means that some of their trades were made with borrowed capital, which magnified their returns; and that instead of holding on to a stock and waiting for it to rise, they bet that the price would fall.

These two practices, though, have long stopped being sufficient to distinguish hedge funds from other investment vehicles. Modern hedge funds trade all sorts of securities more exotic than standard stocks and bonds. And aside from long/short strategies, their styles have become more sophisticated by orders of magnitude; that includes investing in distressed assets, mergers arbitrage, quantitative investing, and much more.

2-and-20: The very high fees of hedge funds

Hedge funds are pioneers in many ways, including in the very high compensation scheme they set up for themselves.

Claiming inspiration from the Phoenician merchants who took for themselves a fifth of the profits of a successful sea voyage, the very first hedge fund kept 20% of the profits of a trade, as well as 2% of the total assets under management. That’s terrifically expensive given that passive index funds may charge you something like 0.2% of your assets, with zero extra charge for profits.

This “2-and-20” model is remarkably persistent across hedge funds, so much so that a law professor has argued that instead of as specialized investment vehicles, hedge funds should be understood as “a compensation scheme masquerading as an asset class.”

In addition to high fees, investors in hedge funds must tolerate another cost. Hedge funds typically make it difficult for investors to withdraw money on short notice. So investors have to agree not to touch their capital, locking it up for a while after they invest, and sometimes over certain periods determined at the manager’s discretion. These contractual restrictions can have dramatic effects for managers and investors; depending on when these restrictions are exercised, investors may not pull out of a bad position, or they pull out too early and contribute to the failure of a good trade.

How well do hedge funds perform?

It’s important to note that the term “hedge fund” should not connote “investment firm of market-beating returns,” just as the term “hedge fund manager” does not necessarily mean “asset manager with extraordinary insight.” A hedge fund is mostly a legal class. Someone with little capital or experience in investing can incorporate as his very own hedge fund: All he needs is a business license. There’s no particular reason to believe that the mere act of incorporation turns a newbie into a skilled investor.

Though there are some very high-performing firms that have generated astonishing returns, hedge funds as a class do not seem to be able to consistently beat the market, especially when fees are accounted for. There are no guarantees that buying into just any hedge fund will earn you very high returns.

Which hedge funds are notable, and who manages them?

One of the first investors who resembled the modern macro trader was the economist John Maynard Keynes. Keynes used leverage and went both long and short on currencies, bonds, and stocks while he managed the endowment for King’s College, Cambridge.

Alfred Winslow Jones, a writer for Fortune magazine, set up the first ever hedge fund in 1949. Jones created what he called a “hedged fund”: An investment vehicle that pioneered the 2-and-20 compensation scheme; that deliberately structured itself to avoid regulatory burdens by taking funds from select private investors; and that employed both leverage and short selling. He generated such extraordinary returns that imitators soon rushed in. Thus an industry grew from the practices of a single firm.

In recent times, even the largest and highest-earning hedge funds can hardly be called household names. Some of these large and high-earning funds include Bridgewater Associates, which manages about $120 billion and styles itself as a “global macro firm”; and Renaissance Technologies, a quant fund staffed mostly by professors of math and physics. Hedge funds that have made news include George Soros’s Quantum Fund, which famously broke the sterling and the will of the Bank of England. You may have also heard of Long-Term Capital Management, whose spectacular meltdown required coordinated intervention from the New York Federal Reserve.

The founders of these hedge funds are special characters in their own rights. Bridgewater is run by Ray Dalio, who sets as required reading a short book called “Principles,” which he wrote himself, about the fundamental lessons of life and the market. Renaissance was founded in 1989 by James Simons, an accomplished math professor who was fired as a code-breaker from the Institute of Defense Analyses when he denounced the Vietnam War. Meanwhile, George Soros was an emigrant from Hungary who witnessed bloody battles in World War II.

Hedge fund founders tend to be people who believe they know an important secret, and the best are able to inspire in their followers a dedication to their views. When he worked for the quant fund D.E. Shaw, a young Jeff Bezos once remarked “It’s easier to focus if you don’t go home.”

Historically notable hedge funds include the eponymous A.W. Jones; Steinhardt, Fine, Berkowitz & Co., run by Michael Steinhardt; Tiger Fund, run by Julian Robertson; the Commodities Corporation, run by Helmut Weymar; Quantum Fund, run by George Soros and Stanley Druckenmiller; Renaissance, run by James Simons; and Long-Term Capital Management, run by John Meriwether and his band of Nobel-prize winners. Each of these firms generated astonishing returns (for some time) and defined the industry in a new way.

It’s also the case that very few of them have lasted into the present. From this list only Renaissance Technologies has been investing continually. Most of the currently-successful hedge funds are not much older than a decade.

Who invests in hedge funds?

“[Hedge funds] are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut,” wrote Clifford Asness, himself a hedge fund manager.

Hedge funds typically manage money for two kinds of investors: the family wealth of high net worth individuals and large institutional firms like pension funds and university endowments.

The early hedge funds sought the funds of only a few high net worth individuals, typically no more than 50, so that they could duck some of the regulations governing mutual funds. Until the last decade, most of the underlying capital of hedge funds came from high net worth individuals.

Recently, however, hedge funds began to get popular with institutional investors: Pension funds, sovereign wealth funds, and endowments for universities and foundations. In 2013 the sources of underlying capital are split roughly evenly between high net worth individuals and institutional investors. In 2018, Citi Investor Services predicts that institutional clients will provide 75% of the underlying capital for hedge funds.

What social functions do hedge funds serve?

Hedge funds are supposed to do well two things that benefit the financial system as a whole: arbitrage and providing liquidity.

First, their trades are supposed to bully mis-priced assets into more reasonable valuations. That way, undervalued securities pick up in price, and overpriced securities are shorted down before they form a bubble. Though hedge funds failed to prevent the last two bubbles, it was not for lack of trying: Hedge funds bet against many tech companies, and many were on the right side of the housing bubble, i.e. holding CDS on the CDOs.

Second, because they trade so often, and in such exotic securities, hedge funds provide liquidity to the system. Someone who wants to make a trade but is afraid of being stuck in an illiquid position may feel more confident that he stands a good chance of winding down well. In other words, hedge funds make it easier for investors to take on the risk they’d like to bear.

These two activities aren’t unique to hedge funds, but hedge funds are supposed to do them especially well.

Critics of hedge funds argue that hedge funds are agents of instability whose rapid trades pose a threat to the financial system. The journalist Sebastian Mallaby has argued that hedge funds are instead forces for stability, and that financial risk is managed by hedge funds better than by any other vehicles. Here’s a sampling of his arguments.

Hedge funds manage risk well

Hedge funds use leverage and unconventional ways to generate returns. Yet they’re far from reckless, and more often tend toward conservatism in their trades.

Hedge funds tend to take fewer risks than investment banks do because their managers have more skin in the game. Consider these characteristics:

Managers have more of their own wealth in the fund

A.W. Jones, who started the first ever hedge fund, invested his own wealth into the fund and directed his own managers to do the same. It’s a fairly common practice that has persisted to this day. When more of their own money, not just their stock options, are on the line, traders have a stronger incentive not to make bad bets.

2. Hedge funds don’t expect bailouts

Banks have repeatedly been the recipients of taxpayer-funded bailouts, most spectacularly in the form of TARP in 2008. Meanwhile, no hedge fund has ever been the recipient of a government bailout. In general, hedge funds are “small enough to fail.” That means that they don’t have good reason to expect much of a safety net in case their trades go wrong.

But wait, what about the case of Long-Term Capital Management? It’s true that the collapse of LTCM was thought to threaten the whole financial system, and that the New York Federal Reserve was sufficiently spooked to intervene. Still, there was no direct bailout of LTCM; instead, the Fed coordinated a private-sector solution to give it a clean burial.

Occasionally, hedge funds that get into trouble are shored up by other hedge funds before their failure would threaten the whole system. This was the case when Citadel purchased the entire portfolio of Amaranth Advisors when it was on the verge of collapse. As Mallaby puts it, “Perhaps hedge funds might occasionally ignite fires. But they could also be the firefighters.”

3. Hedge funds are aggressively monitored by their creditors

To use leverage, hedge funds need to find creditors willing to lend to them.

Typically these creditors monitor very carefully the status of funds. If a hedge fund starts to make losses on a bad trade, then the creditors may well consider recalling loans. There is intense pressure to make every trade a good one, to please both investors and creditors.

Hedge funds tend to make better trades than banks do

Hedge funds are supposed to be sophisticated traders: They’re more secretive; they’re less constricted in the trades they’re allowed to make; and they say they hire the best people working with the best technology. In addition, they have strong incentives to make good bets.

It’s hard to say that hedge funds in general make better trades than banks do, but consider that their robustness has been well on display over the most recent financial crisis.

2008 was a year of chaotic year for the entire financial sector. Yet although quite a few hedge funds failed, the industry as a whole did not lose nearly as much as the banks did.

It was mostly the banks that were securitizing toxic mortgages and then re-securitizing them into collateralized debt obligations, which they held themselves. And it was mostly the hedge funds that stood on the other side, holding credit default swaps on the CDOs. By and large the toxic debt were created and owned by the banks, while the hedge funds bet that they would fail. And the hedge funds were right.

Hedge funds were highly-leveraged, but banks were much more so. Not many hedge funds were leveraged over 10-to-1, while the much bigger banks like Lehman Brothers and Goldman Sachs were leveraged over 30-to-1; the commercial bank Citigroup was supposed to have been leveraged even more highly than that. Meanwhile, the banks with their multiple profit centers did not pay as much attention to risk as the hedge funds did.

Takeaways

Hedge funds are lightly-regulated investment vehicles that generate returns with unconventional strategies. Some have done extraordinarily well, while returns from the average fund aren’t especially high.

Hedge funds arbitrage and provide liquidity to the market. Meanwhile, they may be preferable to banks for managing risk. Hedge funds are usually boutique, expect no lifelines from the government, and monitor their trades more aggressively because they have fewer safety nets. If we want to better manage risk, we may prefer that it’s spread out across hedge funds than concentrated inside giant banks for which taxpayers are responsible.