Hedge Funds
Updated: Sept. 17, 2010
Hedge funds have become a force in the financial markets, controlling trillions of dollars of assets. Even the largest of hedge funds are little known by the public, but what happens at hedge funds matters to just about every American.
In Congress, there has been growing pressure to treat some earnings of hedge fund managers as income instead of capital gains, which are taxed at a lower rate. The House passed a bill on May 28, 2010, that would tax a larger portion of fund managers' compensation as ordinary income. It is expected to raise more than $17 billion in tax revenue over the next decade.
Although similar efforts have died in the Senate for three consecutive years, concerns about the nation's billowing debt are so great that Senate leaders say they expect to pass a measure resembling the one approved by the House.
Hedge funds have expanded beyond their traditional investor base among the uber-rich and raised billions of dollars from pension funds, endowments and foundations. From 1998 to 2008, the number of hedge funds grew from just over 3,000 hedge funds to more than 10,000 and assets within the funds exploded from $374 billion to nearly $2 trillion, according to Hedge Fund Research, a firm in Chicago.
The industry is named for the trading strategy known as "hedging," in which investors place bets in opposite directions to decrease the risk of their trades. But it turned out that most hedge funds had not controlled their risks, and on average, hedge funds lost 18 percent in 2008, according to Hedge Fund Research. As hedge funds spiraled, investors pulled money out.
In a startling comeback, top hedge fund managers rode the 2009 stock market rally to record gains, with the highest-paid 25 earning a collective $25.3 billion, according to the annual AR: Absolute Return+Alpha magazine survey, beating the old 2007 high by a wide margin.
But in 2010, hedge funds, whose outsize returns — and paydays — defined an era of Wall Street riches, are in the midst of a painful shakeout.
Since 2008 investors have withdrawn nearly $320 billion from these private investment pools, leaving the industry’s combined assets at $1.5 trillion, according to data from BarclayHedge.
The industry as a whole struggled in 2008 and 2009, and in 2010 is not looking much better. For the year through the end of August, the average hedge fund was down 1.4 percent, according to Lipper, a unit of Thomson Reuters. Investors are increasingly asking themselves whether they would be better off putting their money in a low-cost index fund. The Standard & Poor’s 500-stock index is up 0.5 percent.
Given that showing, nearly half of the hedge funds included in the Hedge Fund Research Index have been running below the levels they need to attain to earn their rich performance fees for the last three years. (Hedge funds typically charge a management fee of 1 to 2 percent and take a 20 percent cut of profits provided they pass performance milestones known as high water marks.)
Before 2008, hedge funds had had only one down year, 2002, when funds on average lost 1.45 percent. And even the 2002 return was viewed as a positive outcome, given the stock market spiral after the technology bubble burst.
The 2009 recovery of big banks also created huge paydays for hedge fund managers, including a record $4 billion gain for David Tepper of Appaloosa Management, who bet big on the financial sector.
The runner-up in the 2009 ranking was George Soros, the Hungarian émigré who has become better known in recent years for supporting Democratic candidates and making political headlines than for picking stocks. His fund, Quantum Endowment, grew 29 percent in 2009, earning Mr. Soros $3.3 billion in fees and investment gains.
Three managers among the top 10—Mr. Soros (No. 2), James Simons (No. 3) and John Paulson (No. 4)—were back-to-back winners, having profited during the lean times of 2008 as well as in the booming market of 2009.
In 2010, a number of prominent money managers are trying to start afresh after the tumult of the financial crisis. By closing one fund and opening another, managers can, in a stroke, wipe clean their investment records and start collecting fees from new investors.
These funds face two challenges, however. Many have to agree to make up past losses before earning a performance fee from their previous investors — if those investors return at all.
Most also have to indicate to investors that they have learned their lessons and that the investment strategies of their new funds — at least on the surface — will address past problems.
The looming question for these and other managers is whether investors are willing to forgive and forget.
Hedge Funds
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