1.3 How the industry grew

Hedge funds began as a single idea tried by a single fund. Over several decades they grew into an industry that pensions, endowments and insurers treat as a standard part of their portfolios. Along the way, crises exposed their risks, regulators took a closer interest, and the biggest firms changed shape.

This history explains much of what you will see in your work: why hedge funds have notice periods and gates, why managers file reports with regulators, why investors carry out so much due diligence, and why fees are under pressure. This lesson tells the story in broad strokes, by decade rather than by firm.

The first hedged fund and a slow start

In the late 1940s, a fund was launched in the United States that combined two techniques. It bought shares it expected to rise, and it sold short shares it expected to fall. It also used leverage, borrowing to increase the size of its positions. The short positions were meant to protect the fund if the whole market fell, so the fund was described as "hedged". The manager also took a share of the profits as pay, an early form of the performance fee.

The idea was simple: make money from picking the right shares, while reducing exposure to the direction of the market. It was set up as a private partnership for a small group of wealthy investors, which kept it outside many of the rules that applied to funds sold to the public.

For the next few decades, the approach spread slowly. A number of similar funds appeared, especially during strong stock markets, and some closed after difficult periods when their short positions were too small to protect them. Hedge funds remained a small, specialist corner of investing, mostly serving wealthy individuals.

Rapid growth in the 1990s and 2000s

In the 1990s and 2000s, the industry grew rapidly. Several changes came together:

• More strategies. Managers moved well beyond equity long/short. Global macro funds took positions on interest rates, currencies and commodities. Others traded price gaps between related bonds, or bet on mergers and other corporate events. Module 2 covers these strategies.
• New investors. Wealthy individuals were joined by funds of hedge funds, which invest in a range of hedge funds for their clients, and then by pensions, endowments and foundations looking for returns that did not simply follow the stock market.
• Offshore funds. Many managers set up funds outside the US for non-US and tax-exempt investors, alongside their US funds. Lesson 3.1 explains these structures.
• Supporting services. Banks built prime brokerage businesses to lend hedge funds money and securities, and specialist administrators grew to calculate NAVs and keep investor records.

Growth came with warnings. In the late 1990s, some high-profile hedge fund failures showed the dangers of leverage. A fund can borrow to take positions many times the size of its capital. When prices move against it, losses are magnified, lenders ask for more collateral, and the fund may have to sell at the worst possible time. The most serious cases worried regulators because the fund's lenders and trading partners were exposed to its losses too. The lesson was that leverage magnifies losses as well as gains, and that one fund's problems can spread.

The 2008 crisis

The 2008 financial crisis was the industry's hardest test. Many hedge funds suffered heavy losses, despite their aim of protecting investors in falling markets. Investors, many of whom needed cash, asked for their money back at the same time. Redemption requests surged.

Funds holding hard-to-sell assets faced a choice: sell at distressed prices, or limit withdrawals. Many used the tools in their terms:

• Gates, which limit how much can be redeemed on a single dealing date
• Suspensions, which stop redemptions altogether for a time
• Side pockets, which separate hard-to-value assets from the rest of the fund until they can be sold

These tools protected the investors who stayed, but many investors were upset to find they could not get their money out when they wanted it. The crisis also showed counterparty risk, the risk that a firm on the other side of a contract fails. When a major investment bank failed, some hedge funds found their assets held at that bank's prime brokerage were tied up for a long time. Many funds responded by using more than one prime broker.

Regulation and institutionalization

The crisis led to new rules. Before it, many hedge fund managers in the US did not have to register with the securities regulator. Legislation passed after the crisis changed that. Many hedge fund advisers in the US became subject to SEC registration and regular reporting, including confidential reports on their funds' size, leverage and risks. Other regions, including Europe, introduced their own rules for managers of alternative funds.

At the same time, the investor base changed. Institutions such as pension plans, endowments, foundations, insurers and sovereign wealth funds became the main investors in hedge funds. Institutions brought higher expectations:

• Operational due diligence: checks on a manager's controls, valuation, service providers and conflicts, not just its investment skill
• Independent administration: an outside administrator calculating the NAV, rather than the manager alone
• More transparency: more detailed reporting on positions, exposures and risks
• Better terms: fee discounts, capacity rights and other terms negotiated through side letters or separately managed accounts, portfolios run by the manager for a single investor

For many managers, this meant building larger operations, compliance and investor relations teams. Lesson 4.3 covers due diligence from the investor's side.

Platforms and fee pressure

In the 2010s, large multi-manager platforms grew. These firms employ many separate investment teams, each running its own portfolio, under central risk management that cuts back or closes teams that lose too much. The aim is steady returns with low correlation to markets. Many platforms pass their costs, such as team pay, data and technology, through to investors rather than charging only a fixed management fee. Lesson 2.4 explains how this works.

Meanwhile, fees came under pressure. Investors questioned whether many funds earned enough to justify "2 and 20", the historical fee shorthand. Low-cost index funds and public funds using hedge fund-style strategies offered cheaper alternatives. Many managers cut fees, offered lower fees for larger or longer-term commitments, or added hurdles, minimum returns before a performance fee is paid. The industry today is more institutional, more regulated and more concentrated among large managers than in its early decades.

Key terms

• Leverage: Using borrowed money or derivatives to take positions larger than the fund's capital, which magnifies gains and losses.
• Global macro: A strategy that takes positions on interest rates, currencies, commodities and markets based on economic views.
• Fund of hedge funds: A fund that invests in a range of hedge funds on behalf of its own investors.
• Prime brokerage: A bank's services to hedge funds, including lending money and securities, holding assets and clearing trades.
• Side pocket: A separate part of a fund that holds hard-to-value or hard-to-sell assets until they can be realized.
• Counterparty risk: The risk that a firm on the other side of a contract fails to meet its obligations.
• Operational due diligence: An investor's review of a manager's controls, valuation, service providers and conflicts.
• Multi-manager platform: A firm that runs many separate investment teams under central risk management.

Key takeaways

• The first fund described as "hedged", launched in the late 1940s, combined long positions with short sales and leverage; the approach spread slowly for decades.
• The industry grew rapidly in the 1990s and 2000s, and late-1990s failures showed how leverage can magnify losses.
• The 2008 crisis brought losses, heavy redemptions, gates and suspensions, and exposed counterparty risk.
• After the crisis, many US hedge fund advisers became subject to SEC registration and reporting, and institutions became the main investors.
• Large multi-manager platforms grew in the 2010s, while fees across the industry came under pressure.