How hedge funds work

IN FEBRUARY it emerged that nearly half of the richest hedge-fund managers in Britain have donated a total of £10m ($14.8m) to the Conservative party since 2010. Labour, the opposition party, has accused the Tories of dishing out favours, such as a tax loophole, to their “hedge-fund friends”. Earlier this month it turned out that Labour too has relied on at least one very generous hedge-fund friend who has given the party nearly £600,000 since 2012. Hedge-fund managers are renowned for their investment skills and their wealth. But how do these “masters of the universe”, and the funds they control, really operate?

Hedge funds can be traced back to the 1940s, when an unassuming man named Alfred Winslow Jones set up an investment structure that allowed him to bet on both rising and falling prices and to charge a performance fee. The sector rose to prominence (some might say infamy) in the 1990s when George Soros’s speculation against the pound forced sterling out of the Exchange Rate Mechanism; he was thereafter dubbed “the man who broke the Bank of England”. Other so-called “macro” traders such as Julian Robertson and Michael Steinhardt have achieved similar status as market legends. More recently, John Paulson’s bet against subprime mortgage-backed securities turned him into a billionaire. But the lightly-regulated industry has also had its cases of fraud: most notably Bernie Madoff, whose fund turned out to be a Ponzi scheme.

Rather than being an asset class in their own right, hedge funds are best defined by their structure. They are pooled pots of money that are open only to “sophisticated” investors, and which tend to use complex strategies and instruments. Initially, their aim was to produce a positive, or absolute, return in all markets by going short (betting on falling prices) as well as going long (relying on rising prices). For example, a hedge fund might bet on BP, an oil giant, by buying its shares, while shorting the market as a whole. The hedge provided by the short allows the firm to place a bet on a specific company while insulating the fund from the risk of taking a loss as a result of a broad decline in the market. In practice, many hedge funds now eschew hedged strategies in favour of a wide variety of other approaches. Often hedge funds try to exploit quite small market mispricings, a strategy that can nonetheless pay off handsomely if bets are leveraged. Indeed, most funds seek to magnify their bets with borrowed money. This approach can be applied to all sorts of markets, from equities to bonds, currencies and specialist fields such as mergers and acquisitions. To reflect their supposedly high skill, hedge fund managers charge higher fees than mutual-fund managers. Traditionally, they earn “2 and 20”: an annual charge of 2% on the capital under management, plus a 20% performance fee assessed on profits earned (often over some threshold return). This fee structure can pay off generously for managers; Mr Soros (pictured) is worth an estimated $24 billion. High fees have done little to restrain the growth of the industry, which has gone from less than $40 billion of assets under management in 1990 to nearly $3 trillion at the end of 2014.