News Column

Hedge Funds: From Rock Stars to Fallen Stars?

July 28, 2013

Hedge funds were once the rock stars of the financial industry. The smartest people worked for them. The wealthiest gave them their money. They were an easy path to fortune.

But if that get-rich-quick narrative was an exaggeration before the financial crisis, it's even less true since. The hedge fund industry's performance has been spotty in recent years; its public image, bruised. SAC Capital Advisors became the latest high-flyer brought low when the Justice Department on Thursday accused it of allowing insider trading and making hundreds of millions of dollars illegally.

To critics, hedge funds are secretive, risky, loosely regulated playgrounds for the super wealthy. And while the industry keeps expanding, its performance does not. This year could be the fifth in a row that hedge funds underperform the Standard & Poor's 500 stock index, according to Hedge Fund Research, or HFR, which analyzes the industry. That's an unwelcome reversal: For the 19 years from 1990 to 2008, hedge fund returns beat or tied the S&P 500 15 times.

"Everyone says, 'Oh a hedge fund,' and acts like that's some kind of mark of excellence," said Heath Abshure, president of the North American Securities Administrators Association, a group of state securities regulators. "A hedge fund is just an unregistered investment company."

Hedge funds operate by convincing wealthy people to invest with them. They profit by trying to find opportunities that no one else has picked up on, wagering on everything from the price of copper to whether a company will cut its dividend. Some made fortunes predicting the downfall of the U.S. housing market.

The funds try to earn big returns for investors with a variety of strategies, typically including bets for and against the direction of a market. That is meant to provide a hedge, allowing the firm to survive in good economies and bad, and to beat the overall stock

market.

Their birth is generally traced to 1949, but it wasn't until more recently that the industry really took off. In 1990, there were about 600 hedge funds managing $39 billion in assets. Now there are 10,000 firms managing $2.4 trillion, according

to HFR.

The list of industry challenges is long. The explosive growth in the number of funds has increased the pressure to generate the biggest returns and raised the temptation to take undue risks or goad companies for inside information.

The hedge fund industry says that it makes markets more efficient, allocating capital to where it's best used and turning around weak companies. Dan Loeb's involvement at Yahoo, where he successfully pushed for a new CEO and saw the stock price leap, is a case in point. When Loeb, founder of the hedge fund Third Point, announced Monday that he was selling most of his stake in Yahoo, other investors followed suit and the stock price fell 4 percent.

Most Americans don't have any direct involvement with hedge funds - though their mutual funds, pensions or college's endowments might invest in one.


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