The Truth About Hedge Funds and the Financial Crisis

Separating economic fact from economic myth

Veronique de Rugy | March 18, 2011

(Page 2 of 3)

The data, however, does not support such theories. While hedge funds have often seen greater payoffs than the larger financial industry, they have done so while taking fewer risks.

McKinsey Global Institute research shows, for instance, that a significant portion of hedge funds have delivered higher and less volatile returns than investments in public equities and bonds over time, including during the financial crisis.

McKinsey also found that since 1990 investors in hedge funds have earned higher returns than investors whose portfolios contain only equities and bonds. Between 1990 and 2008, an index of hedge funds outperformed a range of blended portfolios of U.S. bonds and equities. The hedge fund index produced 12 percent average annual returns over the period, compared with 7.8 percent for a portfolio of only equities and 7.2 percent for a portfolio of only bonds.

More importantly, hedge funds fared relatively better during the financial crisis than other firms in the industry. In 2008, as losses from the U.S. mortgage market turned into an international financial crisis, global equities dropped 42 percent. Yet hedge funds suffered worldwide losses of just 27 percent.

As the following chart from Shadab’s “Hedge Funds and the Financial Crisis” shows, hedge funds have systematically outperformed the stock market in downturns.

Why? These outcomes are attributable in large part to the legal regime under which they occur. First, federal law enables hedge funds to pursue innovative investment strategies through leverage, short sales, and derivatives. Second, contract law and the hedge fund structure provides fund managers with incentives to innovate while maintaining a relatively healthy balance between risk taking and risk management.

Take the hedge fund compensation scheme. Hedge fund managers are compensated by charging a management fee based upon the size of the fund (typically 1 to 2 percent for hedge funds) but they also charge an annual performance-based fee, typically 20 percent of profits. In addition, they frequently invest their own money in the funds they manage.

This compensation structure generally leads hedge funds to be more prudent in risk-taking than other financial companies. Most hedge fund managers seek to maximize asset size and put much more emphasis on low volatility at the cost of returns so that they can optimize assets under management and asset management fees.

Basically, it is a myth that hedge fund managers are risk takers who seek to maximize returns.

As Shadab notes, “a general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection without wide-ranging regulation.”

Myth 3: Most hedge fund managers are billionaires.

Fact 3: Who cares? But if you must know, the average hedge fund manager’s yearly earnings are $336,000.

We hear all the time that hedge fund managers are billionaires. This belief likely stems from a highly-publicized survey which revealed that in 2009, the 25 highest-paid hedge fund managers earned a collective $25.3 billion, beating the old 2007 high by a wide margin. Yet this number is not representative of the larger hedge fund industry.

Page: < 12 3 >

Reason needs your support. Please donate today!

Try Reason's award-winning print edition today! Your first issue is FREE if you are not completely satisfied.

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment or disable your ability to comment for any reason at any time.

Fist of Etiquette|3.18.11 @ 4:47PM|#

I'd like to leverage Veronique's hedge fund, if you know what I mean.

Even if she does pronounce "ratio" like a foreigner.

Fiscal Meth|3.20.11 @ 3:36AM|#

Veronique seems to have been very libertarian about cocaine before this interview.

|3.18.11 @ 4:51PM|#

This is a good article but it does leave out one fact that many who are critical of hedge funds complain about -- the managers are paid on the "carried interest" method instead of normal income tax rules and thus avoid billions in income taxes.

Old Mexican|3.18.11 @ 5:05PM|#

Re: shrike,

the managers are paid on the "carried interest" method instead of normal income tax rules and thus avoid billions in income taxes.

Oh, the humanity! I shred my garmets! People avoiding being robbed!

What has the world come to when State thieves cannot be successful???

Some Guy|3.20.11 @ 6:17PM|#

So when a certain class of people gets to exempt themselves from the income tax system, you're OK with it, even if it means more of the burden falls on everyone else with earned income to pick up the slack.

Your logic only makes sense if:
1) You believe that less revenue will cause less spending, which can't be farther from the truth.
or
2) You think social engineering is awesome when you relate to the beneficiaries.

Joe|3.24.11 @ 12:32PM|#

So am I evil for contributing to a 401k and IRA, claming my children and deducting my son's tution from my taxes last year?

Before you answer that IS EXACTLY YOUR ARGUMENT. My deductions increased the tax burden for someone else.

|3.18.11 @ 4:59PM|#

Oh hell, I just noticed the Soros picture...

In will come the Beckerhead conspiracy idiots who will insist the great communist-fighting capitalist is a "socialist" simply because Beck said so and he fought creeping GOP fascism 2001-08.

|3.18.11 @ 7:26PM|#

I'm reading "The Big Short" right now, which barely mentions hedge funds. It was the big banks appetite for creating mortgage backed bonds, built on loans they didn't understand. They'd extend bad loans (indeed created entire industries to collect them) so that they could bundle and sell the bonds. Then they started doing credit swaps, so they could create another layer of profit on top of the same loans. AIG was dumb enough to insure the swaps that it didn't understand, and when the loans started defaulting (as housing prices levelled) the resulting need to pay off those huge bets resulted in a cash crunch that caused the whole thing to go tilt. I've explained it poorly, but it is a great read.

sevo|3.18.11 @ 7:38PM|#

Indipolitic|3.18.11 @ 7:26PM|#
"I'm reading "The Big Short" right now, which barely mentions hedge funds."

That's not all it doesn't mention.
From a review:
"But Lewis does not use his 264-page book to even apply one word - not one single utterance - against the malignant government policies behind much of this malaise."
http://www.amazon.com/Big-Shor.....233&sr=1-1

|3.21.11 @ 8:47PM|#

Quite true, and the book would be better with a policy discussion. However, it should be read anyway, he's provided an educated template -- you can insert the policy failings of your choice.

yup|3.18.11 @ 9:33PM|#

I predict this will be over 400 comments.

jacob|3.19.11 @ 6:59PM|#

No. This is something we can all agree upon.

You need something about Palin, gay marriage, or the Ground Zero Mosque to rile up those kind of numbers.

Max|3.18.11 @ 10:32PM|#

Eat something, Veronique, and keep it down.

Max's dream|3.18.11 @ 11:51PM|#

Like what I would do with Obama's man seed.

chaussures air max|3.19.11 @ 1:14AM|#

i like

LOL|3.19.11 @ 2:47AM|#

Interesting.

mbtshoesbest|3.19.11 @ 4:35AM|#

great posting.its worth reading.

http://www.mbtshoesbest.com

jacob|3.19.11 @ 6:57PM|#

Agree that this is a great post.

Whenever I read Veronique's posts on fiscal conservatism, I'm reminded of a post from yesteryear by one of our resident Team Red trolls.

Enjoy

Karl|4.12.08 @ 8:05AM|#
Veronique de Rugy - who is this clown, must be French with a name like that. Crawl back into your institutional echo chamber with your theory's and numbers. Talk about Hit and Run, come back to me when the US has been attacked again but this time by Iranian made dirty bombs after the Democratic Surrender Monkeys have left Iraq. Sadly these events will probably take place in big cities like LA,Philli, NYC, DC, Boston, filled with unexpecting people and mostly of liberals. Us gun toting, bitter church goers with pray for you. I certainly don't need numbers and charts to identify who the enemy is and what they want to our country.

|3.20.11 @ 2:05AM|#

That oldie-but-baddie was both funny and yet also left me bereft of several IQ points.

Though it is a relief to see Team Red admit that it has little regard/penchant for annoying numbers-n-charts-n-facts-n-stuff (which are evil al Qaeda inventions designed to convert our Christian children to homosexuality or some such).

Gilbert Martin|3.20.11 @ 12:45AM|#

The only thing that needed to be said is that no hedge fund was bailed out by the federal government.

That is proof enough that they had nothing to do with it.

|3.20.11 @ 9:00AM|#

Golly gosh,
It wasn't fault of the hedge funds,
Wall Street, Fannie, Freddie, & the banks weren't at fault either. They all say so.

So nobody's at fault. It all just happened, like a meteor strike....

Ekim|3.20.11 @ 10:55AM|#

The primary cause of the crises was wanton printing of debt by world central banks. Hedge funds egged this on by lobbying for more printing of credit, so they could borrow it cheaply.

Will|3.20.11 @ 11:47AM|#

I don't know where to post this but when is Reason going to publish an article supporting the bombing of Libya? I know that's not an opportunity that fake libertarians would pass up... I guess it's related to this article considering the amount of taxpayer money wasted on it that we could just give back to the people that earned it which would help with the economy.

sadhikar|3.21.11 @ 3:35PM|#

The richer get richer and the poor get poorer. Nobody cares. It's all about survival of the fittest.

|3.21.11 @ 5:26PM|#

Spoken like a true progressive.

|3.21.11 @ 9:45PM|#

http://online.wsj.com/article/.....7884e.html

Yeah ok Hedge funds are so good! What a load of bull! They short commodities meanwhile driving them up to make them more profit! Who do you think is contributing to up tick in oil prices! The measly 1.5 million barrels exported from Libya is just a capitalization market!
http://money.cnn.com/magazines...../index.htm
Fools!

|3.31.11 @ 1:03PM|#

How exactly do you short something and drive up the price? You're out of your element. Also, completely ignore that the BRIC economies were raging in mid ’08 and merely slowed down but did not recess (also it was not clear that the US was in big trouble at the point). Speculators can only artificially support a price for so long before it corrects.

Also, what is a "capitalization market"?

As for VDR. “Basically, it is a myth that hedge fund managers are risk takers who seek to maximize returns.” No it’s not. That describes every capitalist (even mom and pop). I believe you meant that it’s a myth that they seek to maximize returns without regard to risk. It’s minor but there are a few spots where your points are not quite clear (in the nuke article too). I’m just suggesting a little more thoughtfulness in your arguments.

sophie|3.30.11 @ 9:14AM|#

Last quote heard from Toni’s dad after abruptly leaving for good upon hearing that his wife was pregnant with their one and only child.

Jan|4.25.11 @ 7:28PM|#

Thanks4Sharing

granite countertop|7.12.11 @ 10:11PM|#

Every day we face with countertop,you can have a high quality of life with granite countertop of yalitongstone,but we will also very pleased if you can see Huaxingstone's granite countertop.

nike shox|8.1.11 @ 9:32PM|#

is good

Jine|10.15.11 @ 1:03PM|#

very nice article on hedge funds and interesting too..

xiingguan|1.10.12 @ 1:30AM|#

This movie has some lebron 9 for sale of the same flaws I saw in another attempt at a faithful adaptation of a work of fantastic literature long thought unfilmable, Zach Snyder’s 2009 version of Watchmen...That is, it lebron 9 china for sale struck me as a series of filmed recreations of scenes from the famous novel

xiingguan|1.10.12 @ 5:37AM|#

asdvgasvcasv

Reason.com