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This article appears in the Spring 2016 issue of The American Prospect. Subscribe here.
In the pilot episode of the Showtime drama Billions, a CNBC host grills Bobby Axelrod (Damian Lewis), founder of the hedge fund Axe Capital, at a public forum. “How do you respond to the criticism that hedge funds are the scavengers of the financial sector, and that a select few have undue influence on the markets?”
“We’re not scavengers,” Axelrod replies. “We’re white blood cells scrubbing out bad companies, earning for our investors, preventing bubbles. A hedge fund like mine is a market regulator.”
This claim invites an important debate: Do hedge funds represent an asset to the larger economy, or a menace? Do they really help make markets more efficient and transparent, or do they just exploit opportunities at the expense of other investors?
There are roughly 11,000 such funds—investment vehicles that control a mix of client dollars and borrowed money, with a corporate structure that exempts them from most investment-company regulations. We know that hedge funds have made a small subset of financial titans fabulously wealthy. The top hedge fund executives make a billion dollars a year or more. Hillary Clinton and Bernie Sanders are fond of saying on the campaign trail that the top 25 hedge fund managers earn more than all of America’s kindergarten teachers combined. But does this orgy of wealth create value, or merely extract value, at the expense of workers, companies, and other investors?
A fictional television show with revenge plots and emotional tumult and the usual allotment of Showtime-mandated soft-core pornography has more pressing concerns than these. It’s beyond the show’s scope to explain how hedge funds became such a disruptive force in our economy and our politics, or to distinguish them from other investment firms, rather than using them as a signifier for “Wall Street jerk.” In fact, amid the twists and turns, Billions barely even begins to explain what a hedge fund does.
HEDGE FUNDS ACTUALLY SPRANG from the widening of a small loophole in New Deal reforms meant to stop companies that trade on behalf of investors from ripping off their clients and threatening economic stability. The Investment Company and Investment Advisers Acts of 1940 prohibited firms operating with pools of investor money from engaging in risky practices like short sales (bets that a stock will go down instead of up), leverage (investing with borrowed funds to amplify returns and heighten risk), and corporate takeovers. Meanwhile, investment companies had to register with the Securities and Exchange Commission (SEC), disclosing their portfolios and their corporate structures. The 1940 laws also restricted certain types of fund manager compensation. The purpose was to eliminate the kind of speculative risks with pools of capital that generated the Great Depression.
The plot of Billions closely resembles the investigation of SAC Capital's Steve Cohen for illegal trading activity. Here, U.S. Attorney for the Southern District of New York Preet Bharara speaks on the case during a news conference, Thursday, July 25, 2013 in New York.
These rules remain in place for the $30 trillion mutual-fund industry, which also invests large pools of client funds. But wealthy families secured a loophole in the 1940 Acts for their own private investment managers. The law exempted advisors with fewer than 100 clients who didn’t offer services to the general public from complying with the regulations. Policymakers justified this by reckoning that “sophisticated investors” can handle the risks, while retail investors—“widows and orphans”—needed to be protected more stringently.
It took less than a decade for Alfred Winslow Jones, a former Fortune magazine scribe, to capitalize on the exemption, creating the first-ever hedge fund. A.W. Jones & Co., a limited partnership, employed two strategies, both explicitly banned by the 1940 Acts: leveraged purchases of certain stocks with borrowed money, and short sales of other stocks. Jones believed that these two techniques in tandem created a conservative, “hedged” portfolio, one that didn’t simply go up or down based on the vicissitudes of the market. “Hedge funds originally were all long/short equity,” says Rob Johnson, president of the Institute for New Economic Thinking and a former managing director at George Soros’s hedge fund. “You own equities, but the long ones are balanced by the short ones. There’s no net exposure to equities.”
Jones also invented the compensation structure used by modern hedge funds: an annual fee of 2 percent of all assets under management, and a 20 percent take of all profits above a certain threshold. Jones claimed he came to this figure because Phoenician sea captains paid themselves one-fifth of the profits after a successful voyage. In reality, that was a fiction to cover a tax dodge; by taking a share of investment profits, Jones could justify the earned income as capital gains, which had a far lower tax rate in 1949 (the top rate on capital gains then was 25 percent; the top marginal income tax rate was 82.13 percent). Today, the same dodge still operates, allowing hedge fund income to be taxed at lower capital gains rates.
Hedge funds claim to be able to beat the market—to achieve above-average returns, known in financial jargon as “alpha.” The fee structure, termed “two and twenty,” theoretically incentivizes and rewards hedge funds for attaining alpha.
The experimental A.W. Jones fund created a new class of money managers outside the regulatory restrictions of the 1940 Acts, with no requirement to disclose positions, even to its own investors. But this largely remained a privilege for the ultra-rich. Over the first 50 years of existence, hedge funds grew slowly; according to research firm BarclayHedge, by 1997 hedge funds only held $118 billion in worldwide assets under management.
But institutional investors, like university endowments and pension funds, wanted to get in on the action. They were attracted by the prospect of earning alpha, and they saw value in alternative investments uncorrelated with market performance. If hedge funds can go up even when the market drops, it diversifies their portfolios.
In 1996, President Bill Clinton signed the National Securities Markets Improvement Act (NSMIA), which overhauled state and federal responsibility for securities market oversight. It was part of a series of market deregulations in the Clinton era, advanced with broad Wall Street support and almost no resistance in Congress: After bipartisan agreement, the House and Senate finalized NSMIA with a voice vote. “We bring the financial markets of this country into the 21st century,” said lead bill sponsor Representative Jack Fields, who shortly thereafter left Congress to found a corporate lobbying shop.
Section 209 of NSMIA, largely unnoticed at the time, expanded the number of clients hedge funds could handle while escaping the 1940 Acts’ rules, from 99 to an unlimited number of “qualified purchasers.” This included individuals with $5 million in investments, and more important, institutional investors with assets of $25 million or more. While the SEC wanted to raise that threshold, Congress “believed that investor protections could be maintained” at $25 million, according to a statement from conferee Representative John Dingell. Clinton didn’t even refer to this part of the law in his signing statement. But hedge funds salivated at the prospect of an entirely new funding source, including tens of billions in retirement savings from ordinary workers.
After NSMIA passed, hedge fund assets increased ten-fold to $1.2 trillion within seven years, and they have doubled again since then. One out of every five university endowment dollars are now invested in hedge funds, according to the National Association of College and University Business Officers. BarclayHedge now estimates hedge fund assets under management in the third quarter of 2015 at $2.7 trillion. And that doesn’t count the borrowed money also invested by the same firms.
Meanwhile, a close cousin of the hedge fund industry, private equity firms, also proliferated. These outfits, previously called leveraged buyout firms (LBOs) until they rebranded after several celebrated scandals in the 1980s, use borrowed money to take control of companies, transform them, and spin them back out. There is overlap in what some hedge funds and some private equity companies do; both can benefit from stripping corporate assets, for example. But in general terms, private equity takes companies private, while equity hedge funds seek trading profits through the purchase and sale of public stock.
What the two have in common is that they live on exemptions from New Deal regulations. With hedge funds, these loopholes sprang from legislation. Private equity firms took advantage of pliant regulators who ignored actions that would not have been tolerated in an earlier era. Though they control companies and sell shares to investors (known as limited partners), private equity firms need not comply with SEC public-company disclosure requirements, because the offerings are considered private. Therefore, in different ways, a large subset of investment companies are exempt from rules requiring disclosures and prohibiting speculative plays—regulations that were created for very good reasons.
Robin Hood: Hedge fund manager and philanthropist George Soros. He crashed the pound—and crashed the party.
This expansion of unregulated investment companies—and the rise of “funds of funds” that allow institutional investors to place money into collections of hedge funds—put at risk the retirement savings of teachers, firefighters, and police officers, and rendered all but meaningless the “limited investor” rule to qualify for regulatory forbearance. As a consequence, hedge funds are among the largest storehouses of aggregated wealth in the financial system. These loopholes also facilitated an expansion in hedge fund investing strategies, where long/short equity became just one technique among many. Most hedge funds no longer hedge; at least, that is not their net investment strategy. On the contrary, most take big risks in pursuit of big rewards. And this transformation underscores how hedge funds stopped being a relatively conservative element of a niche investment strategy and started bigfooting the entire economy.
HEDGE FUND MANAGERS TRAFFIC in myths, all of which fall apart on close examination. The first myth is that they make financial markets more efficient by betting against unsustainable or anomalous trends. A related claim is that they play a kind of regulatory function by policing markets and by putting salutary pressure on corporate executives. For the most part this is nonsense.
For example, in the movie and book The Big Short, the heroes are hedge fund guys who perceived before others did that the housing market, pumped up by subprime loans, was a bubble that would soon burst. The protagonists made a lot of money by betting on a crash before others did. But did this make markets more efficient? The bubble kept inflating and the crash was still horrific. In fact, by creating a market in credit default swaps of housing bonds, hedge funds magnified the impact of the collapse to the financial sector, elevating it from a localized event to a global credit crunch.
Or take the case of William Ackman, whose Pershing Square hedge fund has waged a public battle with the Herbalife Corporation. Ackman contends that Herbalife, a direct marketing company of nutritional supplements, is a pyramid scheme. He has made massive bets against Herbalife, and has spent a small fortune trying to discredit the company so that his bet pays off. So far, the loser has been Ackman. But if Herbalife really is a pyramid scheme, shouldn’t regulators rather than speculators with conflicts of interest be the ones to investigate that allegation? Indeed, there’s a fine line between hedge fund managers disciplining markets and manipulating them; the FBI is investigating whether Ackman made false statements to deliberately tank Herbalife’s stock.
Hedge funds are able to carry out self-fulfilling prophecies. By making big bets against a healthy company’s stock, they can take that company down—as a side effect of the speculation. So the claim that hedge funds function as quasi-regulators, or that this should be an acceptable delegation of responsibility, is preposterous. It’s the opposite of what they do.
Hedge fund managers also argue that they earn super-normal returns through superior knowledge of the global economy, creating the “secret sauce” that allows them to outpace the market. In addition to deciding which companies will succeed or fail, they discover market inefficiencies and identify global trends. They use this knowledge to bet on changes in sovereign bonds, spreads on a country’s corporate bonds, currency fluctuations, or commodity prices like oil. If they see trouble ahead for Asia, they’ll short anything with export exposure to Asian countries. If they think the Eurozone will take off, they’ll make moves there.
Some hedge fund managers do make a lot of money by exploiting such knowledge. For example, George Soros once made more than a billion dollars by crashing the British pound, accurately sensing that it was overvalued. And the business press has bought into the idea of superior insight, treating every pronouncement by hedge fund superstars like Ray Dalio or David Einhorn with the same reverence of a Treasury secretary or finance minister.
But often, the trading edge can come not from immersive study but simply by speaking to the right source. A number of hedge funds have been cited for illegal trading on inside information; the plot of Billions closely resembles the investigation of SAC Capital’s Steve Cohen for illegal trading activity. Recent court rulings threaten to make insider trading putatively legal, but do reveal that, for all the assumptions about deep economic knowledge inside hedge funds, they often get by with tips and rumors.
Most of the other hedge fund money-making strategies involve pure financial engineering: using tax laws, speculative plays, regulatory forbearance, or opportunistic legal maneuvers to hoover up profits from almost anywhere.
For example, distressed-debt hedge funds specialize in finding corporations or sovereign entities in trouble and scooping up their bonds at a discount, and then pursuing aggressive courtroom strategies with the hope that they will be repaid at par, enjoying a huge payday. So-called “vulture” funds like Aurelius Capital Management and NML Capital have moved from Greece to Argentina to Detroit to Puerto Rico, picking at the carrion along the way. This creates huge rewards: In his holdout play in Argentina, Paul Singer of NML won 369 percent of principal on bonds he purchased for pennies on the dollar. Bracebridge Capital did even better, securing eight times the principal value. And winning for the vulture funds equals losing for citizens and workers, who must deal with austerity budgets and public employee layoffs as debt repayment takes precedence.
A handful of hedge funds use high-frequency trading to gain minuscule timing advantages over the market and convert them into profits. An SEC report from last October identified close to four dozen funds employing high-frequency trading, with 28 using it exclusively. These pure arbitrage plays, involving massive cancellations of orders and trades within a microsecond, create little value than placing fractions of a penny into hedge fund accounts millions of times a day. Under the New Deal regulatory schema, this is a modern-day version of a venerable and illegal abuse known as trading ahead of markets. It merely produces profits for the high-frequency traders at the expense of ordinary investors.
So-called “activist” hedge funds accumulate stock in poorly performing companies (or companies with large cash surpluses) to dictate strategies to boards of directors and corporate management that will increase the stock price. Activists have become so feared that just making public statements about management can boost shares, on the assumption that the board will cave. “It’s closer to intimidation by the Mafia than sophisticated business theories,” said Michael Kink, executive director of the union-backed Strong Economy for All Coalition. “Make us rich or we’re going to throw you out the window.”
This is a funhouse-mirror version of the work of private equity companies, which load up operating companies with tax-deductible debt and make their money by extracting dividends, often at the expense of workers or pensioners or investments that the company needs. Activist hedge funds keep the company public, but encourage the board to undertake similar schemes. Hedge funds forced General Motors to buy back $5 billion in stock last year, leaking money to investors instead of improving the company. Activist fund Starboard Value wants to break Yahoo into pieces to extract value. Last year, they forced Darden Restaurants, which owns Olive Garden and other chains, into a sale/leaseback scheme to monetize the value of the company’s real-estate holdings—and hand them to investors.
Shining Sunlight: Senator Tammy Baldwin of Wisconsin wants tighter regulation and better disclosure.
Exerting pressure on firms to improve management and boost the stock price might seem like a mutually beneficial strategy for investors and companies alike. But higher stock returns, while enriching hedge fund investors, don’t necessarily yield rewards for a company or its workers. When activist hedge funds counsel closing an unprofitable factory, outsourcing to a country with lower labor costs, increasing dividends, or buying back shares, they suck out future earnings. Companies must then cut back on the very strategies that make them healthy for the future—investment, R&D, job creation. A recent study from three international researchers finds that activist campaigns decrease the long-term value of the firms they target.
But here is the most revealing false claim of all. Despite all these methods, and despite all the money pouring into the industry, the stark truth about hedge funds is this: On average, most of them don’t beat the market. Their net alpha is zero, or less.
It’s hard to precisely quantify this reality, because hedge funds don’t have stringent disclosure requirements, making it hard to be sure about average performance. For example, the HFR index, designed to track hedge fund performance, likely overstates returns because reporting is voluntary, meaning underperformers could simply opt to hide their numbers. Hedge funds that lose money and close don’t report results either. So the statistics are often skewed in favor of winners. But look at these estimates for last year, provided by LCH Investments. The top 20 hedge funds—out of 11,000—made $15 billion. The rest of the industry lost $99 billion. Even bigshots like Pershing Square’s Bill Ackman lost money in 2015. And this year has begun even more disastrously.
If you go outside the top 20 super-managers, you find that hedge funds underperform in the S&P 500, index funds with a diversified mix of companies, balanced mutual funds, and, according to a Cambridge University study, a collection of stocks picked at random by monkeys. According to other estimates, in 2014, hedge funds overall returned 3 percent; the S&P returned 11 percent. The spread was even worse in 2013.
In fact, hedge funds have lagged the S&P index and other benchmark portfolios going back to the early 2000s. Many investors and even hedge fund managers have acknowledged this for years. And there are analysts who believe that, if you adjust for leverage (the ability to use borrowed money to magnify returns), you can explain virtually all the alpha going back to the original hedge funds in the 1940s. And of course, leverage magnifies the downside as much as the upside. “During the financial crisis a lot of hedge funds went out of business,” says Josh Pollet, associate professor of finance at the University of Illinois. “That tells us a lot about their exposure to risk.”
IF MOST HEDGE FUNDS DON'T outperform the market averages, why do they continue to grow? Why do investors and institutions around the world continue to pay higher fees for lower performance, making a handful of managers notoriously rich?
Practically every expert whom I asked that question had a different rationale. Some chalked it up to investor inertia, a refusal to reckon with the lack of alpha. Related to that is investors’ “reach for yield” in a low-interest-rate environment, where they will sign up with anyone promoting high returns, regardless of the veracity of the claims.
Others believe that even sophisticated investors can be seduced by eye-popping returns at the very top. Large university endowments like Harvard and Yale, for example, have invested in hedge funds for decades, reporting double-digit increases. But that longevity, and the size of their investments, gives them access to top funds like Bracebridge Capital, Yale’s secretive trading firm, and special fee rates available to longtime investors. Other endowments have to settle for smaller shops, and unlike Lake Wobegon, all hedge funds are not above average. A study of the University of California’s endowment shows that their hedge fund investments underperformed the rest of their assets in 10 out of 12 years, costing the university $783 million. Even the Ivies should worry about hedge fund exposure to risk; for all of Harvard’s endowment success, it lost 27 percent in 2009.
Other theories are more sinister. The actual returns from individual hedge funds remain maddeningly opaque, making it hard for investors to know whom to trust.
A picture that reads in Spanish: "VIP Vulture" hangs on a fence outside Congress where lawmakers debate a deal with U.S. creditors in Buenos Aires, Argentina, Wednesday, March 30, 2016. Under the deal, Argentina would pay to resolve all related debt claims, including those from a group led by hedge fund manager Paul Singer's group in New York.
The sales job extends to third-party investment consultants, who have business relationships with the hedge funds to which they funnel investors. The International Business Times has reported on Angeles Investment Advisors counseling the pension fund of San Francisco to invest in hedge funds, when they reserve the right to collect additional fees if the pension fund agrees. Callan Associates, another adviser, has been sued by the retirement fund of Beaumont, Texas, by a private pension fund in New York State, and by others for receiving undisclosed annual payments from the investment funds they pitched to clients. In 2009, Consulting Services Group recommended that the pension fund of Shelby County, Tennessee, invest in a hedge fund that they ran themselves. The most recent disclosure brochure from Lyxor Asset Management, another adviser, states openly that they have a conflict of interest, from a 0.35 percent fee they charge pension funds when they invest in affiliated managers.
Other strategies to rake in public investment capital resemble pay-to-play schemes. “Say I’m an elected official or an appointed official like a pension fiduciary, who needs campaign contributions to prevail in an election,” says INET’s Rob Johnson. “The hedge fund guys say, if you arrange for me to manage $200 million from your pension pool, I’ll put a good portion of the fees into your campaign war chest.” Republican New Jersey Governor Chris Christie passed hundreds of millions in state pension money to hedge funds, and received millions in donations for his gubernatorial and presidential campaigns. As state treasurer of Rhode Island, Democrat Gina Raimondo performed the same trick with over a billion in state resources, using hedge fund donations to help become governor.
Simply projecting outsized returns for hedge fund investments allows a cash-strapped state to provide fewer resources for pensions. Rhode Island can plan to put less into its pension fund if they assume a 10 percent return rather than 5 percent. If they miss the target, that’s the next governor’s problem; what matters is making a projection in the short term that allows them to shortchange public employees. So workers and teachers lose pension money they’re owed so they can make billionaires richer.
The two-decade explosion of hedge funds translates into manager triumphs regardless of returns: 2 percent off the top of the $2.7 trillion invested in 2015 is $54 billion. As author Les Leopold puts it, top managers routinely make a million dollars an hour. A bit of that wealth goes into philanthropy, and plenty more into ostentatious shows of privilege—mansions, yachts, private jets. But significant amounts get poured into the political system, much of it to retain a lax regulatory environment and build a force field around those profits.
Despite a decade of bipartisan support—from Donald Trump to Hillary Clinton—for ending “carried interest,” the term for the maneuver that allows hedge fund managers to take their 20 percent share of profits above benchmark as capital gains instead of earned income, saving billions of dollars in taxes, the loophole remains intact. Various trade organizations and individual hedge funds have spent millions to ensure that. They’ve similarly fought to protect a separate tax loophole for their 2 percent management fees, which involves cycling money through offshore shell companies pretending to sell specialized insurance.
The actions of so-called "activist" hedge funds more closely resemble "intimidation by the Mafia than sophisticated business theories," said Michael Kink, executive director for The Strong Economy for All coalition.
Overall, hedge funds spent $7.34 million in lobbying last year, according to the Center for Responsive Politics. In addition to tax rules, hedge funds have been active in pressing to weaken regulations on derivatives, one of their key trading instruments. Defending the industry from disclosure requirements and limits on activities allows them to gouge their clients with hidden fees. Incredibly, most major institutional investors do not know precisely how much hedge funds charge them. A report from the Roosevelt Institute and the American Federation of Teachers looking at 11 pension funds’ hedge fund investments found that they paid 57 cents in fees for every dollar in net return.
Campaign contributions by hedge funds dwarf their lobbying outlays, as fund managers have become some of the most reliable mega-donors in America. Hedge funds delivered $52 million to candidates during the 2014 midterms, and have already eclipsed that in this cycle. Political reporters herald hedge fund managers siding with presidential candidates, like the $11 million from Renaissance Technologies’ Robert Mercer to support Ted Cruz or the millions Elliott Management’s Paul Singer raised for Marco Rubio, as if they were blue-chip prospects in the NFL Draft. Hedge funds also bankroll think tanks and dark-money groups that seek to privatize public education, among other aims. “They are wildly distorting democratic governmental processes for their own benefit,” says Michael Kink of Strong Economy for All.
All of this would be hard enough to take if hedge funds didn’t also represent a systemic risk. The funneling of massive amounts of wealth to a small collection of billionaires boosts inequality, and activist funds’ extraction of value out of companies hobbles communities and destroys jobs. But for the University of Illinois’s Josh Pollet, it’s hedge funds’ ability to use leverage that hooks them into the broader system, potentially producing a negative shock. While the Dodd-Frank Act did reduce direct sponsorship of hedge funds by big banks, it didn’t limit the ability of hedge funds to borrow capital from banks and engage in risky trades. “If a bunch of hedge funds try the same strategy at the same time, the concern is that hedge funds will do badly, pull down the banks, and the banks are vital for other activity,” Pollet says. Regulators take pride in their efforts to limit leverage by banks. But simultaneously allowing leverage to build in outside investment companies is like boasting about the new lock on the front door while leaving the back door wide open.
HEDGE FUNDS HAVE PUSHED INTO so many aspects of American life that solutions for minimizing their risk have proliferated in parallel. Dodd-Frank forced hedge funds to register with the SEC, but virtually nobody believes that having them give their name, rank, and serial number will make much of a difference. “The SEC doesn’t have the manpower or the technology to regulate hedge funds or any other part of the markets,” says Rob Johnson. Even with registration, hedge fund disclosure is minimal, and their activities, many of which would be banned under the Investment Company Act, can continue freely.
Senator Tammy Baldwin recently introduced legislation that specifically targets activist hedge funds. For more than 50 years, investors have had to disclose to the public when they acquire 5 percent of a company (known as a 13D disclosure). But they can wait up to ten days to disclose. The Baldwin bill would shrink that to two days, limiting the ability for the activist to tip off allies to rush into the fund at a lower stock price, profiting from the spike when the 13D disclosure goes public. This was supposed to be updated as part of Dodd-Frank, but the SEC has dragged its feet.
The bill would also restrict “wolf packs” of activist funds from individually buying just under the 5 percent threshold to skirt disclosure rules. If the wolf pack works together, Baldwin’s bill would count them as a single group and trigger disclosure. Finally, the bill would crack down on how hedge funds use derivatives to mirror their position in a stock, allowing them to amass larger stakes in companies and intimidate management. Often activists will create a “net short” position in a stock, designed to depress the price and expand the windfall. The legislation would put these derivatives under the auspices of the 13D law, forcing disclosure sooner.
Tax reform and tighter controls on high-frequency trading, while broader fights, would attack elements of the hedge fund industry. Reformers like Hedge Clippers, the anti–hedge fund coalition formed last year, also support banning placement agents that cajole investors into funds with which they have a mutual arrangement.
States and municipalities, particularly those with pension investments in hedge funds, can drive change. Last October, Scott Evans, the chief investment officer of the New York City Retirement Systems, demanded full fee disclosure for its hedge fund investments as a condition for future business. Fee disclosure can accelerate a trend of hedge funds cutting fees for investors to limit exits during the current downward cycle; “two and twenty” has increasingly become “one and fifteen.” Hedge Clippers has also called for a cap on exposure to hedge funds and other alternative investments for pension funds and university endowments.
A more radical strategy is to force fiduciaries for institutional investors, bound to operate in the best interest of their clients, to rethink the entire purpose of the hedge fund investment. Currently, most fiduciaries still have this idea that so-called alternative investments like hedge funds enable them to diversify their portfolios and hedge risk, as well as increase yields. But as we’ve seen, hedge funds don’t really hedge anymore. More important, research from analysts as varied as Morgan Stanley, the French business school IPAG, and even the hedge fund AQR shows that hedge fund returns increasingly correlate with the broader market, particularly since the 2008 financial crisis.
If hedge funds go up and down alongside the market, and all but the top performers don’t even beat the market, the rationale for investing in them vanishes. A fiduciary recognizing this would have a duty to investors to step away from hedge funds. That’s already starting: The California Public Employees’ Retirement System, the nation’s largest, pulled out of hedge funds in September 2014, followed by a Dutch health-care workers’ fund the next year.
The quickest way to eliminate the risk to the economy associated with hedge funds is to reclassify them under the 1940 Acts. Their emergence was an accident of history, a gift to wealthy families. But the by-product of that gift has now grown to outsized proportions and shoved itself into practically every aspect of economic life. Putting hedge funds under the 1940 Acts would mandate disclosure, alter fee structures, and eliminate the use of leverage. It would extend the regulatory perimeter in a far sharper way than Hillary Clinton, whose campaign has vowed to rein in “shadow banks” like hedge funds, has so far promised. In effect, putting hedge funds under the wise regulatory structure adopted in 1940 would put them out of business.
Though market forces take a very long time to correct damaging mistakes, sometimes they purge malefactors. For close to a decade, quantitative analysts have built computer programs that mimic hedge fund alpha strategies, generating similar returns through passive rather than active investment, with far lower fees. These have grown to $50 billion in assets, a pittance compared to the hedge fund industry but a 25-fold increase since 2010. Robo-traders come with their own potential abuses and require careful study. But maybe in a few years, outsourced factory workers and hedge fund managers can hold hands in solidarity and demand an end to having their jobs taken away by robots.
Clarification: David Dayen's article on hedge funds included a sentence that Callan Associates was sued by two pension funds for receiving undisclosed fees from investment funds that Callan promoted. This is accurate as written, but the investment funds were not in fact hedge funds.